In the second section of "Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage,” authors Mary Buffett and David Clark took us through Warren Buffett (Trades, Portfolio)’s ideas about balance sheets.
As with the income statement, Buffett uses the balance sheet to search for companies with a durable competitive advantage, a sustainable moat.
In keeping with a protocol that’s now several centuries old, the balance sheet is divided into two sections: (1) assets and (2) liabilities and shareholder equity. Subtract the liabilities from the assets and you’re left with a company’s net worth, or its shareholders’ equity.
The balance sheet looks like this (all figures in millions of dollars):
As the balance sheet in the image shows, there are many kinds of assets; to help distinguish among them, they are divided into two groups:
- Current assets.
- All other assets.
The authors wrote:
“Collectively these two groups of assets make up the company’s total assets. Individually and collectively, via their quality and quantity, they tell Warren a great many things about the economic character of a business and whether or not it possesses the coveted durable competitive advantage that will make him superrich.”
Think of the individual current assets as part of a cycle that looks like this:
- Cash is used to buy inventory.
- Inventory is sold to vendors.
- This becomes accounts receivable.
- Cash used to buy new inventory.
This cycle repeats itself over and over, hopefully becoming larger with each iteration.
Cash and cash equivalents
This line takes in everything that is cash or can be converted into cash quickly, including cash itself and its equivalents, short-term investments, net receivables, inventory and the slush fund titled “other assets.”
If a company has lots of cash, this line tells Buffett one of two things. It has a competitive advantage and is turning out lots of excess cash, a good thing, or it may have just sold a business or some bonds, which may be a negative thing. If he sees lots of cash—with little or no debt—that’s potential buy. However, little cash—with lots of debt—indicates a company may be in trouble and is definitely not a buy prospect. To know what’s what with more certainty, he will look at the previous seven years' worth of balance sheets.
Total inventory
Here, Buffett looks for inventory that is not becoming obsolete and to test that, with manufacturing companies he compares inventory and net earnings. He wants to see both rising in lockstep. In other words, increased sales pointing directly to increasing inventory.
Net receivables
This number is based on total receivables less uncollected receivables. According to the authors, “If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favor that the others don’t have.”
Pre-paid expenses and other current assets
Pre-paid includes items such as insurance, while other current assets are non-cash items due in the coming year but not yet received.
Total current assets and the current ratio
The former number is simply the result of arithmetical calculations, while the latter, the current ratio, shows current assets divided by current liabilities. Generally speaking, the higher the ratio, the more liquid and robust the company. That’s the theory, but in practice, it is of little use because companies with durable competitive advantages have so much earnings power that they can acquire inexpensive, short-term loans if cash is needed. Companies with strong moats do not need to carry as much cash as companies with weak moats.
Property, plant and equipment
These items are carried on the books at original cost less depreciation. Companies in highly competitive markets, or without durable competitive advantages, must constantly update their facilities to remain competitive. As a result, their assets in this area keep growing. But, are they growing with internally-generated cash, or are they growing with debt? At the time of this book's publication, General Motors (GM, Financial) had to take on a lot of debt to keep up with its many competitors. Buffett, needless to say, doesn’t like assets that require constant upgrades.
Goodwill
This is created for an acquiring company when it buys another company for more than its book value. It is no longer amortized against earnings because of an accounting rule change, so it can accumulate on the balance sheet if a company is buying other companies. If goodwill remains the same, it means a company is buying other companies for less than book value or is not making any acquisitions. When such a company becomes available, it is of interest to Buffett.
Intangible assetsÂ
These include patents, copyrights, trademarks, etc. They are also internally-developed assets, so accounting rules say they cannot be carried on the balance sheet. This rule means that companies with durable competitive advantages, including Coca-Cola (KO, Financial) and McDonalds (MCD, Financial), can carry hundreds of billions of dollars worth of intangible value that is not recognized on the balance sheet. The authors explain that this is why Buffett bought Coca-Cola, to the mystification of most observers; it was too expensive for value investors, for example. The guru uniquely saw in the company unrecognized value that could be used to generate long-term earning power.
Long-term investments
This line item takes in stocks and bonds held by a company, as well as its investments in its own subsidiaries and affiliates. These investments must be held on the books at their cost or asset price and cannot be marked up to reflect increased value. This area can also let investors know whether management is investing in businesses with moats, or in markets that are highly competitive.
Other long-term assets
These are assets with value beyond one year, but were not included in other categories such as property and equipment or goodwill. Buffett finds nothing here that informs him about a company’s competitive advantages or disadvantages.
Total assets and return on total assets
Total assets equal current assets plus long-term assets, and together they match total liabilities plus shareholders’ equity. This number also allows analysts to use a return on total assets ratio, which is calculated by dividing net earnings by total assets. Normally, the higher the ratio the better, but Buffett does not like very high ratios because they may suggest potential weakness in a company’s competitive advantage.
Buffett’s thinking goes like this: Proctor & Gamble (PG, Financial) has $143 billion in assets and a return on assets of 7%. Compare that with Moody’s (MCO, Financial) with $1.7 billion in assets and a return on those assets of 43%. One might think Moody’s would be the better buy, but raising $1.7 billion to compete with it would be much easier than raising $143 billion to take on Proctor & Gamble. Thus, Proctor & Gamble’s durable competitive advantage is much stronger than Moody’s, because of the high cost of entry into its business.
As with the income statement, Buffett can learn a lot about a company’s durable competitive advantage, or moat, by studying its balance sheet.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Buffett on Financial Statements: The Income Statement
- Buffett on Financial Statements: A Window Into Warren's Mind
- Secret Hiding Places: Restructuring Opportunities
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