Warren Buffett and the Interpretation of Financial Statements

🎯 The Book in 3 Sentences

💡 Key Takeaways

Seek unique products with high margins and low R&D.
High Gross Profit Margin indicates strong advantage.
Lower SG&A expenses boost profitability.
Consistent net earnings show stable growth.
Strong Current Ratio signifies good liquidity.
Capital Expenditures <50% of Net Earnings is ideal.

✏ Top Quotes

Some men read Playboy. I read annual reports.

Look for businesses in which you think you can predict what they’re going to look like in ten to fifteen years’ time.

📝 Summary + Notes

Introduction

The company must sell a unique product. With advertising promotion, they have placed the stories of their products in our minds, so we think of the to satisfy a need.
Companies that sell the same product for many years, will continue to do so. They will not have to spend millions on R&D and will not have a lot of debt.
Seek for consistency in financial statements.

The Income Statement

**Revenue**: The amount of money that came in the door.
**Cost of Goods Sold**: Either the cost of purchasing the goods the company is reselling or the cost of the materials and labor used in manufacturing the products it is selling. It is called “Cost of revenue” if the company is providing services rather than products.
**Gross Profit**: Revenue - Cost of Goods Sold. How much money the company made after subtracting the costs of the raw goods and the labor used to make the goods.

It is good to calculate Gross Profit Margin. Companies with consistent high number, have a durable competitive advantage. A soft rule is to have over 40%.

$Gross\ Profit\ Margin = \frac{Gross Profit}{Revenue}$

**Selling, General, and Administrative Expenses**: Management salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like. A consistently lower than 30% of the Gross Profit value is fantastic.
**Research and Development**: Warren’s rule: Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.
**Depreciation**: How much the big buys are losing their worth.
**Interest Expense**: The interest that was paid on the company’s debt.
**Gain (or Loss) on Sale of Assets and Other**: Something that is not part of the primary product it sells. So sales of fixed assets, patents, licensing agreements. These are no re-occurring events.
**Income Before Tax**: Income after all expenses have been deducted, but before income tax has been subtracted.
**Income Taxes Paid**: Taxes paid to the government. About 35% of the Income Before Tax in US.
**Net Earnings**: Look for consistent, historical up-trend. Compute its ratio with the Revenue for a meaningful indicator. Look for consistent historical ratio of over 20%.

**Per-Share Earnings:**

It is the net earnings divided by the number of shares outstanding.

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Balance Sheet

**Cash and Cash Equivalents**: Cash, short-term CD at the bank, three-month Treasuries, or other highly liquid assets.
**Inventory**: Products that it has warehoused to sell to its vendors.
**Net Receivables**: Payments that are expected to be received soon. Money that is owed to the company. For example, you buy the product, try for 30 days and then pay.
**Prepaid Expenses**: Businesses sometimes pay for goods and services that they will receive in the near future, although they have not yet taken possession of the goods or received the benefits of the service. Insurance premiums for the year ahead, which are paid in advance, would be one such prepaid expense.
**Other Current Assets:** Non-cash assets that are due within the year but are not as yet in the company's hands. These include such things as deferred income tax recoveries, which are due within the year, but aren’t cash in hand just yet.
Total Current Assets: Use it to compute $Current\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}$. The higher the ratio is, the more liquid the company. A current ratio of over 1 is considered good, and anything below one bad (hard time meeting its short-term obligations). But there are exceptions.
**Property, Plant, and Equipment**: Physical assets of the company. Depreciation is also accounted for.
**Goodwill**: When company “A” buys company “B” and pays in excess of company’s “B” book value, that excess is recorded as goodwill.
**Intangible Assets**: Assets we can't physically touch; these include patents, copyrights, trademarks, franchises, brand names, and the like.
**Long-Term Investments**: Long-term investments (longer than a year), such as stocks, bonds, and real estate are recorded.
Other Long-Term Assets: A giant pool of long- term assets—assets that have useful lives of greater than a year—that didn’t make it into the categories of Property and Equipment, Goodwill, Intangibles, and Long-Term Investments. For example, prepaid expenses and tax recoveries that are due to be received in the coming years.

$Return\ on\ Asset\ Ratio = \frac{Net\ Earnings}{Total\ Assets}$. Measures company’s efficiency.

**Accounts Payable**: Money owed to suppliers that have provided goods and services to the company on credit.
**Accrued Expenses**: Liabilities that the company has incurred, but has yet to be invoiced for. These expenses include sales tax payable, wages payable, and accrued rent payable.
Other Current Liabilities: All short-term debts that didn’t qualify to be included in any other category.
Short-Term Debt: Money that is owed by the corporation and due within the year. This includes commercial paper and short-term bank loans.

Warren has always shied away from companies that are bigger borrowers of short-term money than of long-term money.

Long-Term Debt Due: Long-term debt is not a yearly current liability for most businesses. However, a few very large corporations do have some portion of their long-term debt coming due on a yearly basis.
Total Current Liabilities: $Current\ Ratio = \frac{Total\ Current\ Assets}{Total\ Current\ Liabilities}$
**Long-Term Debt**: Debt that matures any time out past a year. Companies that have enough earning power to pay off their long-term debt in under three or four years are good candidates in our search for the excellent business with a long-term competitive advantage.
Deferred Income Tax: Tax that is due but hasn’t been paid.
Minority Interest: When the company acquires the stock of another, it books the price it paid for the stock as an asset under “long-term investments.” But when it acquires more than 80% of the stock of a company, it can shift the acquired company’s entire balance sheet onto its balance sheet. So the 100% of the acquired companies assets and liabilities will be inside the mother company’s balance sheet. The 20% or less that the company does not own, is show as Minority Interest to balance the 100%.
Other Liabilities: A catchall category into which businesses pool their miscellaneous debt. It includes such liabilities as judgments against the company, non-current benefits, interest on tax liabilities, unpaid fines, and derivative instruments.
**Common Stock**: Common stock represents ownership in the company. Common stock owners are the owners of the company and have the right to elect a board of directors, which, in turn, will hire a CEO to run the company. Common stockholders receive dividends if the board of directors votes to pay them. And if the entire company is sold, it is the common stockholders who get all the loot
**Preferred Stock**: Preferred shareholders don’t have voting rights, but they do have a right to a fixed or adjustable dividend that must be paid before the common stock owners receive a dividend. Preferred shareholders also have priority over common shareholders in the event that the company falls into bankruptcy.

From a balance sheet perspective preferred and common stocks are carried on the books at their par value, and any money in excess of par that was paid in when the company sold the stock will be carried on the books as "paid in capital." So if the company's preferred stock has a par value of $100/share, and it sold it to the public at $120 a share, a $100- a-share will be carried on the books under preferred stock, and $20 a share will be carried under paid in capital.

The same thing applies to common stock, with, say, a par value of $1 a share. If it is sold to the pubHc at $10 a share, it will be booked on the balance sheet as $1 a share under common stock and $9 a share under paid in capital.

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Retained Earnings: Α company’s net earnings can either be paid out as dividends or used to buy back the company’s shares, or they can be retained to keep the business growing. When they are retained in the business, they are added to balance sheet. Retained Earnings is an accumulated number, which means that each year’s new retained earnings are added to the total of accumulated retained earnings from all prior years. Look for consistent increase in retained earnings.
Treasury Stock: The company’s own shares it bought back.
Total Shareholders’ Equity: The amount of money that the company’s owners/shareholders have initially put in and have left in the business to keep it running. Equal to the company’s total assets minus its total liabilities.

$Return\ on \ Shareholders’\ Equity = \frac{Net\ Earnings}{Shareholders’\ Equity}$. High returns on equity mean that the company is making good use of the earnings that it is retaining.

The Cash Flow Statement

Capital Expenditures: Outlays of cash or the equivalent in assets that are more permanent in nature—Held longer than a year— such as property, plant, and equipment. They also include expenditures for such intangibles as patents. Basically they are assets that are expensed over a period of time greater than a year through depreciation or amortization. If it is <50% of its Net Earnings consistently, then the company has a durable competitive advantage.
Stock Buybacks
- Issuance (Retirement) of Stock: If the company sells or (buys back) its shares.
- Issuance (Retirement) of Debt: If the company sells or (buys) debt.

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