Warren Buffett and the Interpretation of Financial Statements

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Warren Buffett and the Interpretation of Financial Statements

The Search for the Company with a Durable Competitive Advantage (2008) By Mary Buffett and David Clark

This is a very interesting book in which I do learnt a few new things about reading the financial statements.

“You have to read a zillion corporate annual reports and their financial statements.” – Warren Buffett

Income statement
1. Companies that have some kind of durable competitive advantage, or excellent long term economics working in their favor tend to have consistently higher gross profit margins than those that don’t example Coco-Cola, Wrigley Co etc.

 

2. Find a company that has low selling, general and administrative expenses (SGA). The lower the better, if it is under 30% it is considered fantastic.

 

3. Steer clear of those companies that require high reserach and development costs. Example if Intel stopped doing research and development, its current batch of products would be obsolete and it would have to go out of business.

 

4.  Depreciation is a real expense. Companies that have a durable competitive advantage tend to have a lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.

Example Coco-Cola’s depreciation expense consistently runs about 6% of its gross profit, while General Motor, which is in a highly competitive capital intensive business has its depreciation expense about 22-57% of its gross profits.

 

5. In any given industry, the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.

 

6. Companies that are busy misleading the tax department are usually hard at work misleading their shareholders as well.

 

7. Companies that show a net earning history of more than 20% on total revenues, is usually one that has some kind of long term competitive advantage.  Those with net earning history of under 10% are more likely in a highly competitive businesss.

One of the exceptions to this rule is banks and financial companies, with an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department. It may indicate an acceptance of greater risk for easier money.

 

8. An increasing per-share earnings figure for a 10 year period can give a very clear picture whether the company has a long term competitive advantage.

 

Balance Sheet

1. If we see a lot of cash and marketable securities and little or no debt, chances are very good that the business will sail on through troubled times.

 

2. Look for an inventory and net earnings that are on a corresponding rise, this indicates that the company is finding profitable ways to increase sales, and that increase in sales has called for an increase in inventory, so the company can fulfill orders on time.

 

3. 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.

 

4. Current ratio may not necessarily give an accurate picture that the company can meet short term debt obligations. Example a current ratio of over one is considered good and anything below one is bad.

The funny thing about a lot of companies with a durable competitive advantage i that quite often their current ratio is below 1. What is really happening is that with their great earning power, they can pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below 1.

 

5. A company that has a durable competitive advantage doesn’t need to constantly upgrade its plant and equipment to stay competitive.

 

6. A company’s long term investments can tell us a lot about the investment mind-set of top management. Do they invest in other business that have durable competitive advantages or they do invest in businesses that are highly competitive markets?

 

7. Capital, always presents a barrier to entry into any industry. Coco-Cola has $43 billion in assets and a return on assets of 12%. Moody’s has $1.7 billion in assets, shows a 43% return on assets. Really high return on assets may indicate vulnerability in the durability of the company’s competitive advantage. Raising $43 billion to take on Coco-cola is an impossible task, but raising $1.7 billion to take on Moody’s is within the realm of possibility.

 

8. One of the indicators of the presence of a durable competitive advantage is a “history” of the company repurchasing or retiring its shares.

 

9. A company that has a durable competitive advantage tend not to have any preferred share. This is because preferred share is an expensive way to raise money.

 

 

 

 

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