Warren Buffett is one of a kind and while he provides amazing insight and knowledge year after year in his letters and speeches, details about how to choose companies and what to look for is lacking.

warren buffett Mr Buffett the Teacher

Warren Buffett and the Interpretation of Financial Statements is a book that manages to explain how Warren Buffett interprets financial statements which we will go through.

How Warren Buffett Interprets the Income Statement

When it comes to analyzing the income statement, it is important to investigate further and drill down to detect what the quality of earnings are made up of and what the numbers interpret.

Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins

  • Durable competitive advantage creates  a high margin because of the freedom to price in excess of cost
  • Greater than 40% = Durable competitive advantage
  • Less than 40% = competition eroding margins
  • Less than 20% = no sustainable competitive advantage
  • Consistency is key

Sales Goods and Administration: Consistency is key.

Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit

  • Less than 30% is fantastic
  • Nearing 100% is in highly competitive industry

R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.

  • High R&D usually dictates high SG&A which threatens the competitive advantage

Depreciation: Using EBITDA as a measure of cash flow is very misleading

  • Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit

Interest Expenses: Companies with high interest expenses relative to operating income tend to be either:

1) in a fiercely competitive industry where large capital expenditure required to stay competitive

2) a company with excellent business economics that acquired debt in leveraged buyout

  • Companies with durable competitive advantages often carry little or no interest expense.
  • Warren’s favorites in the consumer products category all have less than 15% of operating income.
  • Interest expenses varies widely between industries.
  • Interest ratios can be very informative of level of economic danger.

Important: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.

Net Earnings

  • Look for consistency and upward long term trend.
  • Because of share repurchase it is possible for net earnings trend to differ from EPS trend.
  • Preferred over EPS
  • Durable competitive advantage companies report higher % net earnings to total revenues.

Important: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.

  • If net earnings is less than 10%, likely to be in a highly competitive business

How Warren Buffett Interprets the Balance Sheet

Cash and Equivalents:

A high number means either:

1) The company has competitive advantage generating lots of cash

2) Just sold a business or bonds (not necessarily good)

A low stockpile of cash usually means poor to mediocre economics.

There are 3 ways to create large cash reserve.

1) Sell new bonds or equity to public

2) Sell business or asset

3) It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)

When a company is suffering a short term problem, Warren Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.

Important: Lots of cash and marketable securities + little debt = good chance that the business will sail on through tough times.

  • Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal how the cash was created.

Inventory

  • Manufacturers with durable competitive advantages have the advantage that the products they sell do not change, and therefore will never become obsolete. Warren Buffett likes this advantage.
  • When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
  • Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.

Net Receivables

Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables.

If company consistently shows lower % Net receivables to gross sales than competitors, then it usually has some kind of competitive advantage which requires further digging.

Property, Plant & Equipment

A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must replace to keep pace.

Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows, whereas the no advantage company requires debt to finance.

Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think The Coca-Cola Company (NYSE:KO), Johnson & Johnson (NYSE:JNJ) etc.

Goodwill

Whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.

If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.

Intangible Assets

  • Intangibles acquired are on balance sheet at fair value.
  • Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.
  • One of the reasons competitive advantage power can remain hidden for so long.

Total Assets & Return on Total Assets

  • Measure efficiency using ROA
  • Capital is barrier to entry. One of things that make a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
  • Many analysts argue the higher return the better. Warren Buffett states that really high ROA may indicate vulnerability in the durability of the competitive advantage.
  • E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics is far superior to Coca Cola, the durability is far weaker because of lower entry cost.

Current Liabilities

Includes accounts payable, accrued expenses, other current liabilities and short term debt.

  • Stay away from companies that ‘roll over the debt’ e.g. Bear Stearns

When investing in financial institutions, Warren Buffett shies from those who are bigger borrowers of short term than long term debt.

  • His favorite ‘Wells Fargo’ has 57 cents short term debt for every dollar of long term
  • Aggressive banks (like Bank of America) has $2.09 short term for every dollar long term

Durability equates to the stability of being conservative.

Long Term Debt coming Due

Some companies lump their yearly long term debt due with short term debt on the balance sheet. This makes it seem like there is more short term debt than the real amount.

Important: Companies with durable comparable advantages need little or no LT debt to maintain operations.

Too much debt coming due in a single year spooks investors and can offer attractive entry points.

However, a mediocre company in problems with too much debt due leads to cash flow problems and certain bankruptcy.

Long Term

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