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Warren Buffett and the Interpretation of Financial Statements | Book Review

9781416573180

Warren Buffett said, “accounting is the language of business.” I have been learning more about accounting and how to read financial statements. There are a wealth of resources online that provide assistance to investors as they dive into financial statements (Investopedia, Youtube, and the SEC). I went looking for a very simple, introductory book that I could throw on my bookshelf and refer to when I need a refresher. This lead me to Interpretation of Financial Statements.

Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with the Durable Competitive Advantage by Mary Buffett and David Clark

The Interpretation of Financial Statements book is a quick and simple introduction to financial statements. The book takes you through a line by line analysis of the three financial statements:

  1. Income statement;
  2. Balance sheet;
  3. Cash flow statement.

The book focuses on what each line of the financial statement means. Authors Buffett and Clark provide analysis on how Warren Buffett uses these line items to determine if a company has a durable competitive advantage.

Durable Competitive Advantage Through the Interpretation of Financial Statements

Warren Buffett learned that companies that sustain a competitive advantage over their rivals lead to excellent stock returns. This advantage allows these companies to charge more or sell more of their products. Buffett identifies these types of companies using financial statements. Once he identifies a company with a durable competitive advantage Buffett holds them for as long as he can. If you identify and hold these companies for a long period of time wealth can be created.

Buffett determined that business with a durable competitive advantage came in three business models:

  1. Selling a Unique Product: The producers of these unique products have ingrained their use in everyday life. Consumers instinctively reach for these brands. As a result, these brands are immediately recognized and so are their products. The authors use the example of Coca-Cola, Budweiser and Wrigley.
  2. Selling a Unique Service: Like lawyers or doctors companies that sell a unique service sell something that people need and are willing to pay for. Unique service style companies do not have to continually reinvent themselves or pour money into new plants to make goods. The authors use the examples of Moody’s, H&R Block, and American Express.
  3. Being the Low-Cost Buyer and Seller of a Product or Service: The key is to be both the low-cost buyer and the low-cost seller. This results in a business having higher margins than their competitors while remaining the low-cost seller. This will result in higher sales volumes. Examples in the book are Walmart, Costco, and Borsheim Jewelers.

Income Statement

“The Income statement tells the investor the results of the companies operations over a set period of time. Traditionally, they are reported for each three-month period and at the end of the year.”

“An income statement has three basic components: First, there is the revenue of the business. Then there are the firm’s expenses, which are subtracted from the firm’s revenue and tell us whether the company earned a profit or had a loss.”

Gross Profit

Gross Profit Margin= Gross Profit / Total Revenues. Warren Buffett has found that companies with excellent long-term economics have consistently high gross profit margins. A company with a durable competitive advantage allows them to price their goods and services well in excess of the cost to produce them. Buffett believes that a company with over 40% gross profits is a good place to start looking. By comparison, a company with no competitive advantage will have to continually lower their prices to maintain sales, therefore, cutting into their margins.

Selling, General, and Administrative Expenses

Companies that have no durable competitive advantage have SGA expenses that wildly vary. Typically companies that spend a high percentage of their gross profit on SGA expenses are in a very competitive industry. Buffett likes to look for companies that spend under 30% of their gross profits on SGA expenses.

Research and Development Costs

Buffett believes that companies that spend huge sums of money on R&D may develop an advantage, however, that advantage is bound to erode. They must continually spend a high percentage of their gross profit on R&D to stay in business. The book uses the example of Intel. Intel is in the highly competitive computing industry. If Intel fails to spend a significant amount of money on R&D then they will fall behind in the fast-paced world of computing.

Depreciation

Buffett believes that depreciation is a very real expense and should not be excluded when calculating earnings. EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) is a very common metric relied upon by Wall Street analysts. Buffett does not rely on EBITDA as a metric when assessing a company.

When a company depreciates an asset the belief is that it will have to be replaced at the end of its useful life. Warren Buffett likes companies with low depreciation expenses. This indicates that they are in a less competitive industry. Coca-Cola, with depreciation as 6% of gross profits, as an example.

Net Earnings & Earnings Per Share

Deduct all expenses from the revenue and you get net earnings or net income. Net earnings divided by the number of outstanding shares get you earnings per share. A company with a durable competitive advantage will consistently report higher net earnings margin than competitors. Warren uses a simple rule. A business with a consistent 20% net earnings margin is a good margin to look for when assessing a durable competitive advantage.

Balance Sheet

“A balance sheet is broken into two parts: The first part is all the assets, and there are many different kinds of assets. They include cash, receivables, inventory, property, plant, and equipment.”

“The second part of the balance sheet is liabilities and shareholder equity. Under liabilities, we find two different categories of liabilities: Current liabilities and Long-Term liabilities.” Current liabilities means the liability is owed within the year while long-term liabilities come due in one year or more.

“Now if we take all the assets and subtract all the liabilities, we will get the net worth of the business.”

Cash and Cash Equivalents

This asset is exactly what it says, cash. A company can build a large cash pile basically three ways. One, it can sell bonds or equity to the public. Two, it can sell an existing business or asset. Or three, they can continually generate excess cash from their on-going business operations. It is the third category that Buffett seeks out.

Buffett believes that if a company has a large cash pile and little or no debt they should be able to withstand tough economic times. Pretty simple stuff.

Property, Plant and Equipment

Buffett believes that companies that lack a durable competitive advantage are always updating their property, plant and equipment (PP&E). As a result, PP&E keeps adding up on the balance sheet. A company with a durable competitive advantage only replaces equipment when it is worn out, not when competition dictates it. Their equipment is paid for by internal cash flow, not from debt financing.

By producing a consistent product that does not need to be constantly changed a company does not have to continually spend on new equipment. Buffett uses the example of Wrigley Gum versus General Motors. Wrigley has been producing the same product for years with little variation. This is their competitive advantage. In comparison, GM has to continually rebuild their manufacturing facilities to keep up with the competition.

Short-Term and Long-Term Debt

Short-term debt is money that is owed by the company and due within the year. As a rule, companies with durable competitive advantages require little or no long-term debt to maintain their business operations. Long-term debt, by comparison, is due outside of the next twelve months.

With a mediocre company that is experiencing serious problems and too much debt coming due in a year will lead to cash flow problems. As a result, excess debt can lead to bankruptcy. Buffett knows that a company with high-cost debt is a company that cannot sustain.

Cash Flow Statement

The cash flow statement, like the income statement, covers a set period of time. The cash flow statement will tell us if the company is bringing in more cash than it is spending. Cash flow statements and broken down into three parts: Cash flow from operating activity, cash flow from investing operations, and cash flow from financing activities.

Capital Expenditures

Cap ex is cash that is used to purchase assets that are used in the long term operation of the company. Buffett likes companies that do not need to continually pour money into cap ex. If a company is consistently using less than 25% of its net earnings for capital expenditures than you likely have a company with a durable competitive advantage.

Stock Buybacks

Companies with a durable competitive advantage are a profit-generating machine. This causes the issue of what to do with the excess money. One of the options is to buy back the companies own shares. This reduces the number of outstanding shares, which increases the remaining shareholder’s portion of the company. Fewer shares also create an increase in earnings per share.

A history of stock buybacks is a good indicator of a durable competitive advantage. As long as the company isn’t using debt to buy back shares it shows that the company is generating excess cash and looking for a place to invest it.

Conclusion

Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with the Durable Competitive Advantage is a quick and simple book that gives you a better understanding of financial statements.

The authors take you through a line-by-line review of the three vital financial statements. This gives you a basic understanding of what each of these line items means. More importantly, the author provides insight into how Warren Buffett views these line items. Warren Buffett focuses on companies that produce a sustainable product or service. These products or services are engrained in peoples day to day lives. Because of this, these companies do not have to continually spend their money reinventing their products.

This is the durable competitive advantage the Buffett is constantly seeking. A company that can continue to generate cash for its shareholders while minimizing the amount of money that needs to be put back into the business. This type of business leads to market-beating returns when held over a long period of time. In Buffett’s view, the longer the better.

I think this book is more suited to the beginner investor. Someone, like myself, who is new to investing and is unfamiliar with financial statements. The book does have some appeal to more experienced investors. More experienced investors will gain more from the insights the authors provide into Warren Buffett’s identification of durable competitive advantages through the interpretation of financial statements.

My Book Review Classification

I’ve come up with a quick classification system for the books I have reviewed.

Buy: I think you should buy the book. The concepts and teachings in the book are ones that you will continue to revisit so having the book on your shelf is an advantage.

Borrow: Many of the books I review are available at your local library. The library is a great resource and an easy way to save a bit of money. Some of the books are not available at the library so borrowing may not be an option. A “borrow” book is a book I think is worth reading but one that you might not revisit or refer to again.

Burn: A book classified as a “burn” is one I didn’t finish or wish I hadn’t read. Let me spend my time reading these “Burn” books so you don’t have too.

Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with the Durable Competitive Advantage by Mary Buffett and David Clark

Borrow book classification

I think beginner investors would benefit from buying the book and stashing it on the shelf. For the more experienced investor, they are likely very familiar with the contents of financial statements negating half the benefit of the book. In my opinion, the book is still worth a read for the insights on how Buffett interprets financial statements but not necessarily worth the purchase.


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This Post Has 4 Comments

  1. Mannat

    Could you also list down best mobile apps which one can use for tracking/researching/investing?
    Thank you.

    1. Blair

      I don’t use a ton of apps but Yahoo Finance is a decent app for tracking news and your portfolio. CEO.ca is an investing community app. Take the message board with a grain of salt but it is good for getting news from the company and inisder purchases.
      Seeking alpha is useful to get some free research but doesn’t typically provide any microcap coverage.

      1. Ajay

        Are they trust worthy?

        1. Blair

          I do not manage any actual investments in these apps. I use them for informational purposes. I use Questrade to manage my investments which also has an app. You can see my Questrade review here https://battleshipinvesting.com/questrade-review/
          The Questrade app also tracks your investments and you can buy and sell right from the app which is how I mostly use it.

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