Warren

Buffett: Interpreting Financial Statements

Warren Buffett and the Interpretation of Financial Statements taught me how to

interpret an income statement, balance sheet, and cash flow statement in order to find a

company with a durable competitive advantage. The writers, Mary Buffett and David

Clark, explained how to read financial statements from the point of view of Warren

Buffett. Warren Buffett determined that companies with a durable competitive advantage

sell either a unique product or service, or they are the low-cost buyer and seller of a

product or service that the public consistently needs (p.12). Companies that provide a

unique product or service include brand names such as, Coca Cola, Pepsi, and Wrigley.

This report will explain why these companies have a durable competitive advantage.

Warren Buffett always starts by reading the firms income statement. One of the

most important calculations derived from the income statement is the gross profit margin.

To calculate this number, one simply divides gross profit by gross revenue. This number

is the gross profit expressed as a percentage of total revenue. Warren Buffett looks

for companies with a 40 to 60% gross profit margin because they tended to be companies

with unique products or services that possess a competitive advantage.

Next, when analyzing the income statement, Warren Buffett also prefers

companies with small selling, general and administration costs because these companies

tend to be the most efficient. The guru investor avoids companies with large research and

development costs, such as tech companies, as well. He believes that companies with

large R and D costs are not predictable and are risky for investors because there is too

much speculation and competition. For example, Intel spends nearly 30% of its gross

profit on R and D per year. Warren Buffett would much rather invest in companies with

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low R and D costs, such as Coca Cola, which has been producing the same beverage

since 1892. Companies that produce the same good can continuously lower the cost of

production over time, especially as quantity increases. In short, Warren Buffett would

rather invest in production or manufacturing rather than in R and D and SGA expenses.

Gross profit operating expenses yields operating income. This is the profit left over

after the business has paid for the cost of goods sold, SGA, Research and Development,

and depreciation.

It is also important to take into consideration depreciation and interest expenses.

Companies that depreciate at rates over 15% per year are poor investments according to

Warren Buffett. Also, if a business has to spend money on interest expenses, the business

is indebted to its original investors and may be a bad investment. The general rule is that

the company with the lowest ratio of interest payments to operating income is the

company that most likely has a durable competitive advantage. After businesses have

paid for manufacturing, SGA, R and D, and have accounted for depreciation, they must

pay business taxes of around 35% of their income. Operating Expenses Taxes= net

earnings (income). This is probably the most important statistic on the income statement

because it shows how much profit the business has made after paying for everything.

Companies with historical upward trends (5 years+) are companies that Warren Buffett

becomes very interested in investing in. He also says he is more interested in companies

that have high net earnings: total revenue ratio. For example, Warren Buffett would much

rather invest in a company earning 4 billion on 10 billion dollars of revenue than a

company earning 6 billion on 40 billion dollars of revenue.

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 The next step to analyze the Income Statement is to determine the companys per-

share earnings. To do this, simply take net income (net earnings) and divide it by the

number of shares it has outstanding. When looking at a ten-year period of a companys

per-share earnings, Buffett looks for companies with a consistent and upward trend. The

next financial statement that this book discusses is the balance sheet. The main difference

between a balance sheet and an income statement is that a balance sheet provides a

financial summary of a company for a particular day. In short, a balance sheet has three

main categories: assets, liabilities, and shareholder equity. In the end, assets must equal

liabilities + shareholder equity. A balance sheet shows an investor how/where money is

being borrowed from and how/where it is spent.

For example, assets refer to cash, inventory, accounts receivable (inventory sold

to vendors), and pre-paid expenses. The second component of the balance sheet,

liabilities, comprise of all debts. Warren Buffett looks for companies that do not have a

lot of long-term debt nor high interest payments. Assets Liabilities= shareholders

equity, the third component of the balance sheet. This represents the amount of money

that the companys initial investors and shareholders invested and have left in the

business to keep it running. The calculation for market capitalization is to multiply

the price of a share times the number of shares outstanding. This gives the investor a

good idea of how large the company is. Sometimes, shareholders are rewarded with

dividends, which are cash payments made to investors.

Warren Buffett retained 100% of Berkshire Hathways net earnings, which helped

drive its shareholders equity from $19 a share in 1965 to 78,000 a share in 2007 (p. 132).

Buffett did this by stopping the dividend cash payments the day he took control of

the

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company. One type of stock, preferred stock, a type of stock that pays fixed or adjustable

dividends and have priority over common shareholders. One of the most important

components of shareholders equity is retained earnings. Retained earnings represent the

profit that companies invest back in a business. Companies that consistently retain a large

percentage of its shareholders equity tend to have durable competitive advantages.

Companies such as Coca-Cola and Wrigley typically retain 10 to 15% of their net

earnings per year.

One of the most important calculations that Warren Buffett does with the balance

sheet is determining the shareholders return on equity. This is done by taking Net

Earnings and dividing it by shareholders equity. High returns on shareholders equity are

a great sign of a durable competitive advantage. The final financial statement that Mary

Buffett and David Clark analyzed in this book is the cash flow statement. One aspect of

the cash flow statement that Warren Buffett strongly considers is the capital expenditures

category. This includes capital and patents. Buffett does not like patents because

once they expire; the company with the patent loses its competitive advantage.

Companies with durable competitive advantages use between 20 to 35% of its net

earnings to fund capital expenditures i.e. American Express 23%, Coca-Cola 19% (p.

155).

Warren Buffett also buys back stock from his companies, which reduces the

number of shares outstanding and raises the price-per share (treasury stocks). To find this

category on the cash flow statement, search for the title: issuance (retirement of stocks),

net (p. 158). Another important calculation is to take net earnings divided by # of shares

outstanding in order to find the price per share. Companies that have a consistent, upward

trend over a period of 5- 10 years, even by a dollar, tend to be companies with a

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long-lasting competitive advantage. The main way to value a company is to multiply the

price of a share times the number of shares outstanding. This number is called market

capitalization. As opposed to day-traders who monitor the price of the stocks, Buffett is

more concerned with how that stock is growing over time and how a company gets its

money. For example, Warren Buffett initially invested in The Washington Post for $6.36

per share. Twenty years later the stock grew to $54 per share, which gave Warren Buffett a

pretax yield of 849%.

Overall, Mary Buffett and David Clarks Warren Buffett and the Interpretation of

Financial Statements introduced me to an entirely new way of investing. I used to believe

that investors relied on stock speculation. Analyzing financial statements is clearly a

much more profitable, reliable method. It was also interesting that the book discussed

every category of each financial statement and explained what trends to look for and what

calculations are important. I realized that if I read this book every day for 10 days, I

would have most of it memorized and it would be completely worth it. In short, this book

was extremely informative and I intend to use it as a reference for the rest of my life.