Warren Buffett (Trades, Portfolio)'s former daughter-in-law Mary Buffett wrote the best seller " Warren Buffett and the Interpretation of Financial Statements". The book went through how Warren Buffett (Trades, Portfolio) interprets financial statements. Mary Buffett takes you through how Warren Buffett (Trades, Portfolio) analyzes financial statements to find wonderful companies selling at fair value. The book is a must-have for every value investor or any one who want to better understand how to interpret financial statements.
How Warren goes through income statements
When analyzing income statements its important to drill down the quality of earnings of the firm and to figure out what the numbers really mean. You should start with the firm's gross profit margins. Companies with excellent long-term economics tend to have above-average margins.
Gross profit margin
- Greater than 40% = durable competitive advantage.
- Less than 40% = competition eroding margins.
- Less than 20% = no sustainable competitive advantage.
- The key is consistency.
Sales goods and administration:
Companies that don't have a competitive advantage will show a wide variety of SG&A as a percent of gross profit.
- Less than 30% = durable competitive advantage.
- Nearing a 100% = highly competitive industry.
R&D
If the company's competitive advantage comes from a patent or tech advantage, it will at some point disappear.
- High R&D spending usally results in high SC&A this will threaten any company with a competitive advantage.
Depreciation
Warren Buffett (Trades, Portfolio) and Charlie Munger have made it clear their disdane for EBITDA. Don't use EBITDA as a measure of cash flow since it is misleading.
- Companies with a durable competitive advantage tend to have low depreciation as a percentage of gross profits.
Interest expenses
Companies with high interest expenses to operating income to tend to be either:
- In a highly competitive industry where the company needs to make large capital investments to be competitive.
- A company with excellent business economics that acquired debt through a leverage buyout.
- Companies with a durable competitive advantage often have low interest expenses.
- Interest expenses vary widely between industries.
- Interest ratio can alert investors to economic dangers in the company's future.
- Companies with the lowest ratio of interest to operating income in their industry tend to have a competitve advantage.
- Warren Buffett (Trades, Portfolio) likes to use pretax earnings to interest expenses. Companies whose pretax earnings exceed interest expenses by two times tend to be companies Buffett likes to invest in.
Net earnings
- Look for a consistent upwards trend in net earnings.
- Net earnings trends can differ from earnings per share because of stock buybacks.
- Buffett prefers net earnings over earnings per share.
- Companies with competitive advantages tend to have higher net earnings as a percentage of revenues than their competitors.
- Companies with net earnings greater than 20% of total revenues tend to have a competitive advantage than their competitors.
How Buffett interprets the balance sheet
Cash and cash equivalents:
A high level of cash and cash equivalent on the balance sheet means either:
- Because the company has a competitive advantage it produces a lot of cash.
- Company just sold a business or bonds this play not be good.
There are three ways to create large stockpiles of cash:
- Sell new bonds or equity to the public.
- Sell business or asset.
- Ongoing business generates more cash than it burns.
Inventory
- Manufacturer with durable competitive advantage sells products that don't change. Their products don't become obsolete.
- Look for manufacturers with inventory and net earnings that rise correspondingly. This usually means that company has a durable competitive advantage.
- Manufacturers whose inventory spike up and down tend to mean that the firm is in a very competitive industry.
Net receivables
Net receivables can tell you a lot about different competitors in the same industry. In some competitive industries, a company will try to gain an advantage by offering better credit terms this causes sales and receivables to increase. Companies with low net receivables as a percentage of gross sales tend to have a competitive advantage over competitors.
Property plant and equipment:
Companies with durable competitive advantages don't need to constantly upgrade equipment to stay competitive. A company with a competitive advantage finances new equipment with internal cash flow while the one without a competitive advantage does with debt. Companies that produce consistent product don't need to to upgrade plants which free up cash for other ventures. Think of companies like Coca-Cola (KO, Financial), Johnson & Johnson (JNJ, Financial) and Hershey (HSY, Financial).
Goodwill
Companies that go out and buy other companies will see an increase in goodwill over a number of years. This is because the companies purchase other companies for more than book value. Businesses whose goodwill stays the same over time are either acquiring companies for less than book value or not acquiring.
Intangble assets
- Internally developed brand names (Coke, Hershey and Band-Aid) are not reflected in the balance sheet.
- Intangibles that are acquired are on the balance sheet at fair value.
- Intangible assets are one of the reasons a competitive advantage could be hidden for so long.
Total assets and return on total assets
- Measure Return on Assets.
- One of the things that makes a competitive advantage durable is the cost of assets needed to get in.
- Warren Buffett (Trades, Portfolio) say a really high ROA may indicate vulnerability for a firm's durable competitive advantage.
- Example: To compete with Coca-Colaa company would need to raise $48 billion but to compete with Moody's (MCO, Financial) you just need to raise $1.7 billion. Moody's has a higher ROA and better economics than Coca-Cola; however, Coca-Cola's durability is far greater than Moody's.
Current liabilities
Current Liabilities includes accounts payable, accrured expenses, other current liabilities and short-term debt. When investing in cmpanies who borrow large sums of short-term debt rather than long-term debt. Make sure company is conservative in its borrowing and does not have excessive debt levels.
Long-term debt coming due
There are companies that lump their yearly long-term debt with short term debt on the balance. This makes it look like those companies have more short-term debt then they really have. Companies with durable competitive advantages need little to no long-term debt to maintain operations.
Long-term debt
Companies with durable competitve advantages are so profitable they can internally finance expansions and acquisitions with cash and don't need debt. Look at the last 10 years of long-term debt to see if it grows, shrinks or stays consistent.
Total liabilities-and-debt-to-shareholders equity ratio:
- Debt-to-Equity Ratio = Total Liabilities/ Total Shareholder Equity.
- Debt to Equity ratio helps identify whether a company uses debt or cash to finance operations.
- Company with earning power tend to show higher levels of equity and lower levels of liabilities.
- When debt-to-equity ratio is lest than 0.8, the company has a durable competitive advantage.
Retained earnings, treasury stock and cash flow statements will be done in part 2 of How Warren Buffett Interprets Financial Statements.
