How do you identify an exceptional company with a durable competitive advantage from the CASH FLOW STATEMENTS?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

CASH FLOW STATEMENTS

The cash flow statement keeps track of the actual cash that flows in and out of the business.

A company can have a lot of cash coming in, through the sale of shares or bonds and still not be profitable.

A company can be profitable with a lot of sales on credit and not a lot of cash coming in.

The cash flow statement will tell us if the company is bringing in more cash than it is spending (“positive cash flow”) or if it is spending more cash than it is bringing in (“negative cash flow”).

Cash flow statements like income statements cover a set period of time.

The cash flow statement has three sections:

·               Cash flow from operating activities

·              Cash flow from investing activities

·              Cash flow from financing activities

Cash flow from operating activities

Net income + depreciation & amortization = Total Cash from Operating Activities

Depreciation and amortization are real expenses from an accounting point of view.

They don't use up any cash because they represent cash that was spent years ago.

Cash flow from investing activities

This area includes an entry for all capital expenditures made for that accounting period.

Capital expenditure is always a negative number because it is an expenditure which causes a depletion of cash.

Total Other Investing Cash Flow Items adds up all the cash that gets expended and brought in, from the buying and selling of income producing assets.

If more cash is expended than is brought in, it is a negative number.

If more cash is brought in than is expended, it is a positive number.

Capital Expenditure + Other Investing Cash Flow Items = Total Cash from Investing Activities

Cash flow from financing activities

This measures the cash that flows in and out of a company because of financing activities.

This includes all outflows of cash for the payment of dividends.

It also includes the selling and buying of the company’s stock.

When the company sells shares to finance a new plant, cash flows into the company.

When the company buys back its shares, cash flows out of the company.

The same thing happens with bonds.

Sell a bond and cash flows in; buy back a bond and cash flows out.

Cash Dividends Paid + Issuance (Retirement) of Stock, Net + Issuance (Retirement) of Debt, Net  = Total Cash from Financing Activities

Net Change in Cash

Total Cash from Operating Activities + Total Cash from Investing Activities + Total Cash from Financing Activities = Net Change in Cash

Some of the information found on a company’s cash flow statement can be very useful in helping us determine whether or not the company in question is benefiting from having a durable competitive advantage.

Capital Expenditures

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature – held longer than a year – such as property, plant and equipment.

They also include expenditures for such intangibles as patents.

They are assets that are expensed over a period of time greater than a year through depreciation and amortization.

Capital expenditures are recorded on the cash flow statement under investment operations.

When it comes to making capital expenditures, not all companies are created equal.

Many companies must make huge capital expenditures just to stay in business.

If the capital expenditures remain high over a number of years, they can start to have deep impact on earnings.

As a rule, a company with durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.

Coca Cola spent 19% of its last ten years total earnings for capital expenditure.  Moody spent 5% of its total earnings for the last ten years for capital expenditure.

GM used 444% more for capital expenditure than it earned over the last ten years.  Goodyear (tire maker) used 950% more for capital expenditure than it earned over the last ten years.

For GM and Goodyear, where did all that extra money come from?

It came from bank loans and from selling tons of new debt to the public.

Such actions add more debt to these companies’ balance sheets, which increases the amount of money they spend on interest payments and this is never a good thing.

Both Coke and Moody’s, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. 

Both these activities helped to identify the businesses with a durable competitive advantage working in their favour.

When looking at capital expenditures in relation to net earnings, add up a company’s total capital expenditures for a ten year period and compare the figure with the company’s total net earnings for the same ten year period.

The reason we look at a ten year period is that it gives us a really good long term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures.

If a company is historically using 50% of less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.

If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favour.

Stock Buybacks

Companies that have a durable competitive advantage working in their favour make a ton of money.

The companies can sit on this cash, or they can reinvest it in the existing business or find a new business to invest in. 

If they don’t require the cash for the above, they can also either pay it out as dividends to their shareholders or use it to buy back shares.

Shareholders have to pay income tax on the dividends.  This doesn’t make anyone happy.

A neater trick is to use some of the excess money that the company is throwing off to buy back the company’s shares.

This reduces the number of outstanding shares – which increases the remaining shareholders’ interest in the company – and increases the per share earnings of the company, which eventually makes the stock price go up.

If the company buys back its own shares it can increase its per share earnings figure even though actual net earnings don’t increase.

The best part is that there is an increase in the shareholders’ wealth that they don’t have to pay taxes on until they sell their stock.

To find out if a company is buying back its shares, go to the cash flow statement and look under Cash from Investing Activities, under a heading titled “Issuance (Retirement) of Stock, Net”.

This entry nets out the selling and buying of the company’s shares.

If the company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.

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

How do you identify an exceptional company with a durable competitive advantage from the SHAREHOLDERS' EQUITY OF THE BALANCE SHEET?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

BALANCE SHEET

The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.

Assets minus Liabilities = Net worth or Shareholders' Equity

Shareholders’ Equity/Book Value

Shareholders’ Equity is accounted for under the headings of

·         Capital Stock (Preferred and Common Stock);

·         Paid in Capital and

·         Retained Earnings

Shareholders’ Equity is an important number as it allows us to calculate the return on shareholders’ equity.

Return on shareholders’ equity is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in it favour.

Preferred and Common Stock, Additional Paid in Capital

From a balance sheet perspective preferred and common stocks are carried on the books at their par value, and any money in excess of par that was paid in when the company sold the stock will be carried on the books as “paid in capital.”

If the company’s preferred stock has a par value of $100/share, and it sold it to the public at $120 a share, a $100 a share will be carried on the books under preferred stock and $20 a share will be carried under paid in capital. 

The same thing applies to common stock, with say, a par value of $1 a share.  If it is sold to the public at $10 a share, it will be booked on the balance sheet as $1 a share under common stock and $9 a share under paid-in capital.

Companies that have durable competitive advantage tend not to have any preferred stock. 

This is in part because they tend not to have any debt. 

They make so much money that they are self financing.

While preferred stock is technically equity, in that the original money received by the company never has to be paid back, it functions like debt in that dividends have to be paid out.

Interest paid on debt is deductible from pretax income.  

However, dividends paid on preferred stock are not tax deductible, which tends to make issuing preferred shares very expensive money.

Because it is expensive money, companies like to stay away from it if they can. 

One of the markers we look for in our search for a company with durable competitive advantage is the absence of preferred stock in its capital structure.

Retained Earnings

A company’s net earnings can either be paid out as dividends or used to buy back the company’s shares, or they can be retained to keep the business growing

When they are retained in the business, they are added to an account on the balance sheet, under shareholders’ equity called retained earnings.

If the earnings are retained and profitably put to us, they can greatly improve the long-term economic picture of the business.

To find the yearly net earnings that are going to be added to the company’s retained earnings pool, take the company’s after tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year.

Retained Earnings is an accumulated number, which means that each year’s new retained earnings are added to the total of accumulated retained earnings from all prior years.

If the company loses money, the loss is subtracted from what the company has accumulated in the past. 

If the company loses more money than it has accumulated, the retained earnings number will show up as negative.

Retained Earnings is one of the most important number, on the balance sheet that can help us determine whether the company has a durable competitive advantage. 

If a company is not making additions to its retained earnings, it is not growing its net worth.

If it is not growing its net worth, it is unlikely to make any of us super rich over the long run.

Simply put:  the rate of growth of a company’s retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage. 

Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses. 

When two companies merge, their retained earnings pools are joined, which creates an even larger pool.

General Motors and Microsoft both show negative retained earnings.

General Motors:  it shows a negative number because of the poor economics of the auto business, which causes the company to lose billions.

Microsoft:  it shows a negative number because it decided that its economic engine is so powerful that it doesn’t need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.

Berkshire Hathaway:  Warren Buffett stopped its dividend payments the day he took control of the company.  This allowed 100% of the company’s yearly net earnings to be added into the retained earnings pool.  As opportunities showed up, he invested the company’s retained earnings in businesses that earned even more money and that money was all added back into the retained earnings pool and eventually invested in even more money making operations.   As time went on, Berkshire’s growing pool of retained earnings increased its ability to make more and more money.

From 1965 to 2007, Berkshire’s expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.

The more earnings that a company retains, the faster it grows its retained earnings pool, which in turn will increase the growth rate for future earnings. 

The catch is, it has to keep buying companies that have a durable competitive advantage.

Treasury Stock

When a company buys back its own shares, it can do two things with them. 

It can cancel them (and the shares cease to exist) or it can retain them with the possibility of reissuing them later on (and they are carried on the balance sheet under shareholders’ equity, as treasury stock).

Shares held as treasury stock have no voting rights, nor do they receive dividends and though arguably an asset, they are carried on the balance sheet at a negative value because they represent a reduction in the shareholder’s equity.

Companies with a durable competitive advantage because of their great economics, tend to have lots of free cash that they can spend on buying back their shares. 

One of the hallmarks of a company with a durable competitive advantage is the presence of treasury shares on the balance sheet.

When a company buys its own shares, and holds them as treasury stock, it is effectively decreasing the company’s equity, which increases the company’s return on shareholders’ equity.

Since a high return on shareholders’ equity is one sign of a durable competitive advantage, it is good to know if the high returns on equity are being generated by financial engineering or exceptional business economics or because of a combination of the two.

To see which is which, convert the negative value of the treasury shares into a positive number and add it to the shareholders’ equity instead of subtracting it. 

Then divide the company’s net earnings by the new total shareholders’ equity. 

This will give us the company’s return on equity minus the effects of financial engineering.

Treasury shares are not part of the pool of the outstanding shares, when it comes to determining control of the company.

The presence of treasury shares on the balance sheet and a history of buying back shares, are good  indicators that the company in question has a durable competitive advantage working in its favour.

Return on Shareholders’ Equity

Shareholders’ equity equal to the total sums of preferred and common stock, plus paid in capital, plus retained earnings and less treasury stock.

Shareholders in a company would be interested in how good a job management does at allocating their money so that they can earn even more.

Financial analysts developed the return on shareholders’ equity equation to test management’s efficiency in allocating the shareholders’ money.   

It measures the management’s ability to profitably put shareholders’ equity to good use.

Warren Buffett use the return on shareholders’ equity in his search for the company with a durable competitive advantage.

Return on Shareholders’ Equity = Net Earnings / Shareholders’ Equity

Companies that benefit from a durable or long term competitive advantage show higher than average returns on shareholders’ equity.

Companies with no sustainable competitive advantage tend to have low returns on equity.

High returns on equity mean that the company is making good use of the earnings that it is retaining. 

As time goes by, these high returns on equity will add up and increase the underlying value of the business, which over time, will eventually be recognized by the stock market through an increasing price for the company stock.

Some companies are so profitable that they don’t need to retain any earnings, so they pay them all out to the shareholders.  

In these cases, its shareholders’ equity may be a negative number.

Insolvent companies will also show a negative number for shareholders’ equity.

If the company shows a long history of strong net earnings, but shows a negative shareholders’ equity, it is probably a company with a durable competitive advantage.

If the company shows both negative shareholders’ equity and a history of negative net earnings, we are probably dealing with a mediocre business that is getting beaten up by the competition.

High returns on shareholders equity means “come play.”

Low returns on shareholders equity means “stay away.”

Leverage

Leverage is the use of debt to increase the earnings of the company.

A company using leverage can increase its earnings and its return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage when it, in fact is just using large amounts of debt.

Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings.

It creates the appearance of some kind of durable competitive advantage, even if there isn’t one.

In assessing the quality and durability of a company’s competitive advantage, avoid businesses that use a lot of leverage to help them generate earnings. 

In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.

How do you identify an exceptional company with a durable competitive advantage from the LIABILITIES IN THE BALANCE SHEET?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

BALANCE SHEET

The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.

Assets minus Liabilities = Net worth or Shareholders' Equity

Current Liabilities

Account Payable, Accrued Expenses and Other Current Liabilities

Accounts payable is money owed to suppliers that have provided goods and services to the company on credit.

Accrued expenses are liabilities that the company has incurred but has yet to be invoiced for.  

These expenses include sales tax payable, wages payable and accrued rent payable.

Other Liabilities is a slush fund for all short term debts that didn’t qualify to be included in the above categories.

Account payable, accrued expenses and other debts can tell us a lot about the current situation of a business but as stand alone entries they tell us little about the long term economic nature of the business and whether or not it has a durable competitive advantage.

However, the amount of short and long term debt that a company carries can tell a great deal about the long term economics of a business and whether or not it has a durable competitive advantage.

Short Term Debt

This includes commercial paper and short term bank loans.

Short term money is cheaper than long term money.

It is possible to make money borrowing short term and lending it long term. 

We just borrow more money short-term to pay back the short term debt that is coming due (rolling over the debt). 

The problem works well until the short term rates jump above what you lent the money long at. 

You have to refinance your short term debt at a rate in excess of what you loaned it out at.

Another problem of borrowing short term to lend this money long term is when your creditors decide not to loan you any more money short term. 

Suddenly you have to pay back all that money you borrowed short term and lent long term (e.g. Bear Stearns). 

The smartest and safest way to make money in banking is to borrow it long term and lend it long term.

When it comes to investing in financial institutions, you should shy away from companies that are bigger borrowers of short-term money than of long-term money. 

While being aggressive can mean making lots of money over the short term, it has often led to financial disasters over the long term. 

In troubled financial times, it is the stable conservative banks that have the competitive advantage over the aggressive banks that have gotten themselves into trouble.

The durability equates with the stability that comes with being conservative. 

It has money when the others have losses, which creates opportunity.

Aggressive borrowers of short term money are often at the mercy of sudden shifts in the credit markets, which puts their entire operation at risk and equates with a loss of any kind of durability in their business model.

Long Term Debt Coming Due in current year

As a rule, companies with a durable competitive advantage require little or no long-term debt to maintain their business operations and therefore have little or no long term debt ever coming due.

A company that has a lot of long term debt coming due, we probably are not dealing with a company that has a long term competitive advantage.

Buying a company that has a durable competitive advantage going through troubled times due to a one time solvable event, it is best to check how much of the company’s long term debt is due in the years ahead. 

Too much debt coming due in a single year can spook investors, which will give us a lower price to buy in at.

With mediocre company that is experiencing serious problems, too much debt coming due in a current year can lead to cash flow problems and certain bankruptcy.

Total Current Liabilities and the Current Ratio

A current ratio of over one is considered good and anything below one, bad. 

But, as previously discussed, companies with a durable competitive advantage often have current ratios under one.

Current ratio is of great importance in determining the liquidity of a marginal to average business, it is of little use in telling us whether or not a company has a durable competitive advantage.

Long Term Debt

Long term debts are debts that mature anytime out past a year.

The amount of long term debt a company carries on its books tells a lot about the economic nature of the business.

Companies that have a durable competitive advantage often carry little or no long term debt on their balance sheets.

This is because these companies are so profitable that they are self financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money.

Take a look at the long term debt load that the company has been carrying for the last ten years and not just in the current year.

If there have been ten years of operations with little or no long term debt on the company’s balance sheet it is a good bet that the company has some kind of strong competitive advantage working in its favour.

The company should have sufficient yearly net earnings to pay off all of its long term debt within a three or four year earnings period.

Companies that have enough earning power to pay off their long term debt in under three or four years are good candidates in the search for the excellent business with a long term competitive advantage.

These companies are so profitable and carrying little or no debt, they are often the targets of leveraged buyouts. 

This is where the buyer borrows huge amounts of money against the cash flow of the company to finance the purchase.

After the leveraged buyout, the business is then saddled with large amounts of debts.

In cases like these, the company’s bonds are often the better bet, in that the company’s earning power will be focused on paying off the debt and not growing the company.

Deferred Income Tax, Minority Interest and Other Liabilities

Deferred Income Tax is tax that is due but hasn’t been paid.

This figure tells us little about whether or not the company has a durable competitive advantage.

When a company acquires the stock of another, it books the price it paid for the stock as an asset under long term investments.

When it acquires more than 80% of the stock of a company, it can shift the acquired company’s entire balance sheet onto its balance sheet. 

The same applies to the income statement.

The Minority Interest entry represents the value of the acquired company that the acquirer does not own.

This shows up as a liability to balance the equation, since the acquirer booked 100% of the acquired company’s assets and liabilities, even though it owns from 80% to less than 100%.

What does Minority Interests have to do with identifying a company with a durable competitive advantage? 

Not much.

Other Liabilities:  This is a catchall category  that includes such liabilities as judgments against the company, non-current benefits, interest on tax liabilities, unpaid fines and derivative instruments. 

None of these helps us in our search for the durable competitive advantage.

Total Liabilities and the Debt to Shareholders’ Equity Ratio

The debt to shareholders’ equity ratio can be used to help us identify whether or not a business has a durable competitive advantage.

The debt to shareholder’s equity ratio helps us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings).

The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders’ equity and a lower level of total liabilities.

The company without a competitive advantage will be using debt to finance its operations and therefore should show just the opposite, a lower level of shareholders’ equity and a higher level of total liabilities.

Debt to Shareholders’ Equity Ratio = Total Liabilities / Shareholders’ Equity

The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don’t need to maintain any shareholders’ equity. 

Because of their great earning power, they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. 

That in turn, increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business – one without a durable competitive advantage. 

It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders’ equity ratio. 

If we add back into the equity the value of all the treasury stock acquired through stock buybacks, then the debt to equity ratio of these companies with durable competitive advantage can be clearly noticed.

With financial institutions like banks, the ratios, on average tend to be much higher than those of their manufacturing cousins.

Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for.

This leads to an enormous amount of liabilities which are offset by a tremendous amount of assets.

On average, the big banks have $10 in liabilities for every dollar of shareholders’ equity they keep on their book.  

That is, banks are highly leveraged operations.

The simple rule:  unless we are looking at a financial institution, any time we see an adjusted debt to shareholders’ equity ratio below 0.8 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for. 

Debt/Equity = Total Liabilities/Equity# , <0 .8="" better.="" lower="" o:p="" the="">

#Treasury share adjusted

How do you identify an exceptional company with a durable competitive advantage from the ASSETS OF THE BALANCE SHEET?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

BALANCE SHEET

The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.

Assets minus Liabilities = Net worth or Shareholders' Equity

Assets

Current Assets:  Cash and cash equivalents, short-term investments, net receivables, inventory and other assets.

Non Current Assets:  Long Term investments, Property Plant and Equipment, Goodwill, Intangible Assets, Accumulated Amortization, Other Assets and Deferred Long Term Asset Charges.

Individually and collectively, via their quality and quantity, tell a great many things about the economic character of a business and whether or not it possesses the coveted durable competitive advantage that will make an investor super rich.

Current Asset Cycle

Cash --> Inventory -->  Accounts Receivable -->  Cash.

This cycle repeats itself over and over again and it is how a business makes money.

Cash and Cash Equivalent

Companies traditionally keep a hoard of cash to support business operations.

A company basically has three ways of creating a large stockpile of cash.

·         It can sell new bonds or equity to the public, which creates a stockpile of cash before it is put to use.

·         It can also sell an existing business or other assets that the company owns, which can also create a stockpile of cash before the company finds other uses for it.

·         Or it has an ongoing business that generates more cash than the business burns.

Look at the past seven years of balance sheets. 

This will reveal whether the cash hoard was created by a one-time event, such as the sale of new bonds or shares, or the sale of an asset or an existing business, or whether it was created by ongoing business operations.  

If we see lots of debts, we probably are not dealing with an exceptional business.

But if we see a ton of cash piling up and little or no debt and no sales of new shares or assets and we also note a history of consistent earnings, we are probably seeing an excellent business with a durable competitive advantage - the kind of company that will make us rich over the long term.

A company that is suffering a short-term business problem may see its shares sold down in the stock market.   

Look at its cash or marketable securities that the company has hoarded away to gain an idea whether it has the financial strength to weather the troubles it has gotten itself into.

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 the troubled times.  

But if the company is hurting for cash and is sitting on a mountain of debt, it probably is a sinking ship that not even the most skilled manager can save.

Inventory

With a lot of businesses, there is a risk of inventory becoming obsolete.

Manufacturing companies with a durable competitive advantage have an advantage, in that the products they sell never change and therefore never become obsolete.

To identify a manufacturing company with a durable competitive advantage, 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 the increase in sales has called for an increase in inventory, so the company can fulfill orders on time.

Manufacturing companies with inventories that rapidly ramp up for a few years and then, just as rapidly, ramp down are more likely than not companies caught in highly competitive industries subject to booms and busts.  

And no one ever got rich going bust.

Net Receivables

Receivables - Bad Debts = Net Receivables

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 favour that the others don't have.

Prepaid Expenses/Other Current Assets

Insurance premiums for the year ahead, which are paid in advance is an example of prepaid expense.

Prepaid expenses offer us little information about the nature of the business or about whether it is benefiting from having a durable competitive advantage.

Total Current Assets and the Current ratio

The higher the current ratio, the more liquid the company is.

A current ratio of over one is considered, good and anything below one, bad.

If it is below one, it is believed that the company may have a hard time meeting its short term obligations to creditors.

A lot of companies with a durable competitive advantage often have current ratios below one.

Their earning power is so strong they can easily cover their current liabilities.

Also, as a result of their tremendous earning power, these companies have no problem tapping into the cheap, short-term commercial paper market if they need any additional short term cash.

Because of their great earning power, they can also pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below one.

There are many companies with a durable competitive advantage that have current ratios less than one.

Such companies create an anomaly that renders the current ratio almost useless in helping us identify whether or not a company has a durable competitive advantage.

Property, Plant and Equipment

These are carried at their original cost, less accumulated depreciation.

Depreciation is what occurs as the plant and equipment wear out little by little; every year, a charge is taken against the plant and equipment.

The company that has a durable competitive advantage replaces its plant and equipment as they wear out, while the company that doesn’t have a durable competitive advantage has to replace its plants and equipment to keep pace with the competition.

A company with a durable competitive advantage will be able to finance any new plants and equipment internally. 

But a company that doesn’t have a competitive advantage will be forced to turn to debt to finance its constant need to retool its plants to keep up with the competition. 

Producing a consistent product that doesn’t have to change equates to consistent profits. 

The consistent product means there is no need to spend tons of money upgrading the plant and equipment just to stay competitive which frees up tons of money for other money-making ventures.

Goodwill

The FASB (Financial Accounting Standards Board) decided that goodwill wouldn’t have to be amortized unless the company that the goodwill was attached to was actually depreciating in value.

Whenever we see an increase in goodwill of a company over a number of years, we can assume that it is because the company is out buying other businesses. 

This can be a good thing if the company is buying businesses that also have a durable competitive advantage.

If the goodwill account stays the same year after year, that is because either the company is paying under book value for a business or the company isn’t making any acquisitions. 

Businesses that benefit from some kind of durable competitive advantage almost never sell for below their book value. 

Occasionally it does happen and when it does, it can be the buying opportunity of a lifetime.

Intangible Assets

Intangible assets are assets we can’t physically touch:  patents, copyrights, trademarks, franchises, brand names and the like.

Companies are not allowed to carry internally developed intangible assets in their balance sheets.

Intangible assets that are acquired from a third party are carried on the balance sheet at their fair value. 

If the asset has a finite life – as a patent does – it is amortized over the course of its useful life with a yearly charge made to the income statement and the balance sheet.

The real value of some companies that benefit from durable competitive advantage may be understated.  

For example, its strong brand name is worth a lot and yet because it is an internally developed brand name, its real value as an intangible asset is not reflected in its balance sheets.

Coke’s brand name is worth a lot. The intangible asset of Coke is its brand that gives it durable competitive advantage and the long term earning power that came with it.

Short of comparing ten years’ worth of income statements, investors have had no way of knowing it was there or knowing of its potential for making them super rich.

Long Term Investments

This records the value of long term investments (longer than a year): stocks, bonds and real estate, investments in the company’s affiliates and subsidiaries.

This asset class is carried on the books at their cost or market price, whichever is lower.  

It cannot be market to a price above cost even if the investments have appreciated in value.

This means that a company can have a very valuable asset that is carrying on its books at a valuation considerably below its market price.

A company’s long-term investments can tell us a lot about the investment mind set of top management.

Do they invest in other businesses that have durable competitive advantages or do they invest in businesses that are in highly competitive markets (mediocre businesses)?

Watch out for management of a wonderful company buying mediocre companies.

Also search for  and love the management of a mediocre company buying companies with durable competitive advantage e.g. Berkshire Hathaway.

Other Long Term Assets

Examples are paid expenses and tax recoveries that are due to be received in the coming years.

These tell us little about whether or not the company in question has a durable competitive advantage.

Total Assets and the Return on Total Assets

Return on total asset ratio is found by dividing net earnings by total assets.

It tells us how efficient the company is in putting its assets to use.

Capital is always a barrier to entry into any industry.

One of the things that helps make a company’s competitive advantage durable is the cost of the assets one needs to get into the game.

The really high returns on assets may indicate vulnerability in the durability of the company’s competitive advantage.

Moody’s (total assets $ 1.7 billion, ROA 43%)

Coca Cola’s (total assets $ 43 billion, ROA 12%)

While Moody’s underlying economics is far superior to Coca Cola’s, the durability of Moody’s competitive advantage is far weaker because of the lower cost of entry into its business.