What you look for in the financial statements of those great businesses with durable competitive advantage

 

Warren Buffett’s Financial Statement Rules of Thumb:

INCOME STATEMENT:

1: Gross Margin

Equation: Gross Profit / Revenue

Rule: 40% or higher

Buffett's Logic: Signals the company isn’t competing on price.

2: SG&A Margin

Equation: SG&A Expense / Gross Profit

Rule: 30% or lower

Buffett's Logic: Wide-moat companies don’t need to spend a lot on overhead to operate.

3: R&D Margin

Equation: R&D Expense / Gross Profit

Rule: 30% or lower

Buffett's Logic: R&D expenses don't always create value for shareholders.

4: Depreciation Margin

Equation: Depreciation / Gross Profit

Rule: 10% or lower

Buffett's Logic: Buffett doesn't like businesses that need to invest in depreciating assets to maintain their competitive advantage.

5: Interest Expense Margin

Equation: Interest Expense / Operating Income

Rule: 15% or lower

Buffett's Logic: Great businesses don’t need debt to finance themselves.

6: Income Tax Expenses

Equation: Taxes Paid / Pre-Tax Income

Rule: Current Corporate Tax Rate

Buffett's Logic: Great businesses are so profitable that they are forced to pay their full tax load.

7: Net Margin (Profit Margin)

Equation: Net Income / Sales

Rule: 20% or higher

Buffett's Logic: Great companies convert 20% or more of their revenue into net income.

8: Earnings Per Share Growth

Equation: Year 2 EPS / Year 1 EPS

Rule: Positive & Growing

Buffett's Logic: Great companies increase profits every year.

BALANCE SHEET:

9: Cash & Debt

Equation: Cash > Debt

Rule: More cash than debt

Buffett's Logic: Great companies don't need debt to fund themselves.

10: Cash & Debt

Equation: Cash > Debt

Rule: More cash than debt

Buffett's Logic: Great companies generate lots of cash without needing much debt.

11: Adjusted Debt to Equity

Equation: Total Liabilities / Shareholder Equity + Treasury Stock

Rule : < 0.80

Buffett's Logic: Great companies finance themselves with equity.

12: Preferred Stock

Rule: None

Buffett's Logic: Great companies don't need to fund themselves with preferred stock.

13: Retained Earnings

Equation: Year 1 / Year 2

Rule: Consistent growth

Buffett's Logic: Great companies grow retained earnings each year.

14: Treasury Stock

Rule: Exists

Buffett's Logic: Great companies repurchase their stock.

CASH FLOW STATEMENT:

15: Capex Margin

Equation: Capex / Net Income

Rule: <25%

Buffett's Logic: Great companies don't need much equipment to generate profits.

Caveats:

There are plenty of exceptions to these rules.

CONSISTENCY IS KEY!

What "rules of thumb" do you use?

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"Warren Buffett and the Interpretation of Financial Statements" By Mary Buffett