The Income Statement: The Earning Test

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

1.       Earning Test

WHERE WARREN STARTS: THE INCOME STATEMENT

Income Statement
($ in millions)
Revenue	$10,000
Cost of Goods Sold	3,000
Gross Profit	7,000
Operating Expenses
Selling, General & Admin	2,100
Research & Development	1,000
Depreciation	700
Operating Profit	3,200
Interest Expense	200
Gain (Loss) Sale Assets	1,275
Other	225
Income Before Tax	1,500
Income Taxes Paid	525
Net Earnings	$975

In his search for the magic company with a durable competitive advantage, Warren always starts with the firm's income statement. Income statements tell the investor the results of the company's operations for a set period of time. Traditionally, they are reported for each three-month period and at the end of the year. Income statements are always labeled for the time period they cover-such as January 1, 2007, to December 31, 2007.

An income statement has three basic components: First, there is the revenue of the business. Then there is 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. Sounds simple, doesn't it? It is.

In the early days of stock analysis the leading analysts of the time, such as Warren's mentor Benjamin Graham, focused purely on whether or not the firm produced a profit, and gave little or no attention to the long-term viability of the source of the company's earnings. As we discussed earlier, Graham didn't care if the company was an exceptional business with great economics working in its favor or if it was one of the thousands of mediocre businesses struggling to get by. Graham would buy into a lousy business in a heartbeat if he thought he could get it cheaply enough.

Part of Warren's insight was to divide the world of businesses into two different groups: 

• First, there were the companies that had a long-term durable competitive advantage over their competitors. These were the businesses which, if he could buy them at a fair or better price, would make him superrich if he held them long enough. 
• The other group was all the mediocre businesses that struggled year after year in a competitive market, which made them poor long-term investments.

In Warren's search for one of these amazing businesses, he realized that the individual components of a company's income statement could tell him whether or not the company possessed the super-wealth-creating, long-term durable competitive advantage that he so coveted. Not just whether or not the company made money. But what kind of margins it had, whether it needed to spend a lot on research and development to keep its competitive advantage alive, and whether it needed to use a lot of leverage to make money. These factors comprise the kind of information he mines from the income statement to learn the nature of a company's economic engine. To Warren, the source of the earnings is always more important than the earnings themselves.

For the next fifty chapters we are going to focus on the individual components of a company's financial statement and what Warren is searching for that will tell him if this is the kind of business that will send him into poverty, or the golden business with a long-term durable competitive advantage that will continue to make him one of the richest people in the world.