In the third section of their book, “Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage,” authors Mary Buffett and David Clark examined the format of cash flow statements and explained what Warren Buffett (Trades, Portfolio) looks for in them.
As for what Buffett is looking for, they give us a hint in this quotation from the guru at the top of the chapter: “There is a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn’t require capital.”
Also at the top of the chapter, an explanation of the rationale for cash flow statements. It revolves around the two methods for recognizing that a company has booked new revenue. Using the cash method, recognition occurs when the cash actually arrives; using the accrual method, recognition occurs when the goods arrive in the hands of customers, but have not yet been paid for.
Since most companies provide credit of some kind, they prefer to use the accrual method, which allows them to recognize their revenue sooner. Because of this discrepancy between the time revenue is booked and when the cash arrives, accountants created the cash flow statement. It also helps track the amount of investment or debt that has flowed in or out of the corporation in a specific quarter or year.
The first section of the cash flow statement deals with operating activities:
As shown, this is calculated by adding depreciation and amortization to net income. Neither depreciation nor amortization requires current cash because they represent cash spent earlier.
The second section shows cash flow that comes from investments. This takes in all capital expenditures (capex) during the period in question. This number must be negative because it is an expenditure, which takes cash out:
Third, there is cash flow from financing. It includes cash-in and cash-out from buying or selling its own stock, from buybacks and from dividends. Selling corporate bonds brings in cash, buying them pushes cash out:
Finally, all these activities are summed up to produce the net change in cash:
That wraps up the format section, and we turn to Buffett’s approach to the cash flow statement. While no doubt he reads it all closely, there are a couple of areas that receive special attention.
The first is capital expenditures, which represents cash used for relatively permanent assets, assets that last more than one year. For example, when a company buys a truck, it incurs a capital expenditure, but the gasoline used to fuel the truck does not.
Capital expenditures are typically for property, plant and equipment in traditional goods producing companies. For tech companies, on the other hand, it might be the cost of buying intangible items such as patents. As the different sections of the cash flow statement suggest, a company makes a capital expenditure to buy an asset, then in subsequent years depreciates or amortizes that cost.
Some types of companies require more or less capex than other types of companies. For example, the authors say Buffett has not invested in telephone companies because they require vast amounts of capital to keep up with their competition.
He expects companies with durable competitive advantages, or a solid moat, will not need such large outlays of capital. Here are a few companies that illustrate that contrast, as of the book’s publication in 2008:
- Coca-Cola (KO, Financial) used 19% of its total earnings for capital expenditures.
- Moody’s (MCO, Financial) needed just 5% of total earnings for capex.
- Goodyear (GT, Financial) used some 950% of its earnings on capex.
Regarding troubled companies such as Goodyear, they spent far more than their earnings, so it was necessary to fill the gap with debt from bank loans and selling bonds to the public.
For companies such as Coca-Cola and Moody’s, their low capex spending allowed them to buy back shares and take other measures, including the repayment of debts.
Bear in mind that investors should look at cash flow statements for 10 years when analyzing the relationship between net earnings and capital expenditures. This allows them to look beyond variations of one or a few years.
Buffett uses a couple of hurdle rates in this analysis:
- A company that uses 50% or less of its annual net earnings for capital expenditures is worth checking for a durable competitive advantage.
- If that figure is 25% or less, there is a high likelihood the company does have a moat.
The retirement of stock, more informally known as stock buybacks, is the other key area for Buffett. When companies have strong competitive advantages, they often are throwing off more cash than they can effectively use. If they don’t wish to sit on that cash or make acquisitions, they can either issue dividends or buy back stocks.
Buffett is a big fan of companies that buy back stock rather than pay dividends. There is a simple reason for his preference: buybacks are not taxed, while dividends are. Also, capital gains taxes must be paid when an asset is sold, but if you rarely sell, as has been the practice at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), you rarely pay tax.
Buybacks also increase each remaining stockholder’s proportionate interest. Fewer shares mean fewer claimants on a company’s earnings and, therefore, each remaining shareholder gets a bigger piece of the pie.
In both cases, more money stays in investors’ pockets and that accelerates the pace of compounding. When compounding occurs within a company, its intrinsic value increases and other investors are willing to pay a higher price to buy its shares. That has been one of the great secrets of Berkshire Hathaway, which has grown so much under the shrewd leadership of Buffett and his colleague Charlie Munger (Trades, Portfolio).
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: Balance Sheet, Shareholders' Equity
- Buffett on Financial Statements: Balance Sheet Liabilities
- Buffett on Financial Statements: Balance Sheet Assets
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