Debt test of Warren Buffett

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

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

3. Debt Test

"One of the things you will find---which is interesting and people don't think of it enough---with most businesses and with most individuals, is life tends to snap you at your weakest link. The two biggest weak links in my  experience: I've seen more people fail because of liquor and leverage---leverage being borrowed money."

                                      Warren Buffett

   

     INTEREST EXPENSE: WHAT WARREN DOESN'T WANT

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

Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability. While it is possible for a company to be earning more in interest than it is paying out, as with a bank, the vast majority of manufacturing and retail  businesses pay out far more in interest than they earn.

This is called a financial cost, not an operating cost, and it is isolated out on its own, because it is not tied to any production or sales process. Instead, interest is reflective of the total debt that the company is carrying on its books. The more debt the company has, the more interest it has to pay.

Companies with high interest payments relative to operating income tend to be one of two types: 

• a company that is in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or 
• a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

What Warren has figured out is that companies with a durable competitive advantage often carry little or no interest expense. Long-term competitive advantage holder Procter & Gamble has to pay a mere 8 % of its operating income out in interest costs; the Wrigley Co. has to pay an average 7%; contrast those two companies with Goodyear, which is in the highly competitive and capital-intensive tire business. Goodyear has to pay, on average, 49% of its operating income out in interest payments.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage. The consistently profitable Southwest Airlines pays just 9% of operating income in interest payments, while its in-and-out-of-bankruptcy competitor United Airlines pays 61% of its operating income out in interest payments. Southwest's other troubled competitor, American Airlines, pays a whopping 92% of its operating income out in interest payments.

As a rule, Warren's favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income. But be aware that the percentage of interest payments to operating income varies greatly from industry to industry. As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in interest payments, which seems high compared with Coke's, but actually makes the bank, out of America's top five, the one with the lowest and most attractive ratio. Wells Fargo is also the only one with a AAA rating from Standard & Poor's.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in. Take the investment banking business, which on average makes interest payments in the neighborhood of 70% of its operating income. A careful eye would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the quarter that ended in November 2007, its percentage of interest payments to operating income had jumped to 230%. This means that it had to dip into its shareholders' equity to make up the difference. In a highly leveraged operation like Bear Stearns, that spelled disaster. By March of 2008 the once mighty Bear Stearns, whose shares had traded as high as $170 the year before, was being forced to merge with JP Morgan Chase & Co. for a mere $10 a share.

The rule here is real simple: 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. In Warren's world, investing in the company with a durable competitive advantage is the only way to ensure that we are going to get rich over the long-term.

LONG-TERM INVESTMENTS: One of the secrets to Warren's success

LONG-TERM INVESTMENTS: ONE OF THE SECRETS TO WARREN'S SUCCESS

Balance Sheet/Assets
($ in millions)
Total Current Assets	$12,005
Property/Plant/Equipment	8,493
Goodwill, Net	4,246
Intangibles, Net	7,863
+ Long-Term Investments	7,777
Other Long-Term Assets	2,675
Total Assets	$43,059

This is an asset account on a company's balance sheet, where the value of long-term investments (longer than a year), such as stocks, bonds, and real estate is recorded. This account includes investments in the company's affiliates and subsidiaries. What is interesting about the long-term investment account is that this asset class is carried on the books at their cost or market price, whichever is lower. But it cannot be marked 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 it 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? Sometimes we see the management of a wonderful business making huge investments in mediocre businesses for no other reason than they think big is better. Sometimes we see some enlightened manager of a mediocre business making investments in companies that have a durable competitive advantage. This is how Warren built his holding company Berkshire Hathaway into the empire that it is today. Berkshire was once-upon-a-time a mediocre business in the highly competitive textile industry. Warren bought a controlling interest, stopped paying the dividend so cash would accumulate, and then took the company's working capital and went and bought an insurance company. Then he took the assets of the insurance company and went on a forty-year shopping spree for companies with a durable competitive advantage.

Kiss even a frog of a business enough times with a durable competitive advantage and it will turn into a prince of a business.

Or, as in Warren's case, $60 billion, which is what his stock in Berkshire is now worth.

                              -------------------------

Return on Shareholders' Equity

SHAREHOLDERS' EQUITY/BOOK VALUE

Balance Sheet/Shareholders' Equity
($ in millions)
Total Liabilities	$21,525
Preferred Stock	0
Common Stock	880
Additional Paid in Capital	7,378
Retained Earnings	36,235
Treasury Stock--Common	-23,375
Other Equity	626
Total Shareholders' Equity	21,744
Total Liabilities + Shareholders' Equity	$43,269

When you subtract all your liabilities from all your assets you get your net worth. If you take a company's total assets and subtract its total liabilities you get the net worth of the company, which is also known as the shareholders' equity or book value of the business. This is the amount of money that the company's owners/shareholders have initially put in and have left in the business to keep it running. Shareholders' Equity is accounted for under the headings of Capital Stock, which includes Preferred and Common Stock; Paid in Capital, and Retained Earnings. Add together Total Liabilities and Total Shareholders' Equity and you get a sum that should equal Total Assets, which is why it is called a balance sheet---both sides balance.

Why Shareholders' Equity is an important number to us is that it allows us to calculate the return on shareholders' equity, which is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in its favor.

Let's check it out.

RETURN ON SHAREHOLDERS' EQUITY: PART ONE

Balance Sheet/Shareholders' Equity
($ in millions)
Preferred Stock	0
Common Stock	880
Additional Paid in Capital	7,378
Retained Earnings	36,235
Treasury Stock--Common	-23,375
Other Equity	626
Total Shareholders' Equity	21,744

Shareholders' equity is equal to the company's total assets minus its total liabilities. That happens to equal the total sums of preferred and common stock, plus paid in capital, plus retained earnings, less treasury stock.

Shareholders' equity has three sources. 

• One is the capital that was originally raised selling preferred and common stockto the public. 
• The second is any later sales of preferred and common stock to the public after the company is up and running. 
• The third, and most important to us, is the accumulation of retained earnings.

Since all equity belongs to the company, and since the company belongs to the common shareholders, the equity really belongs to the common shareholders, which is why it is called shareholders' equity.

Now if we are shareholders in a company, we would be very interested in how good a job management does at allocating our money, so we can earn even more. If they are bad at it we won't be very happy and might even sell our shares and put our money elsewhere. But if they are really good at it we might even buy more of the company, along with everyone else who is impressed with management's ability to profitably put shareholders' equity to good use. To this end, financial analysts developed the return on shareholders' equity equation to test management's efficiency in allocating the shareholders' money. This is an equation that Warren puts great stock in, in his search for the company with a durable competitive advantage, and it is the topic of our next chapter.

RETURN ON SHAREHOLDERS' EQUITY: PART Two

Calculation: Net Earnings divided by Shareholders' Equity equals Return on Shareholders' Equity.

What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholders' equity. Warren's favorite, Coca-Cola, shows a return on shareholders' equity of 30%; Wrigley comes in at 24%; Hershey's earns a delicious 33%; and Pepsi measures in at 34%.

Shift over to a highly competitive business like the airlines, where no one company has a sustainable competitive advantage, and return on equity sinks dramatically. United Airlines, in a year that it makes money, comes in at 15 %, and American Airlines earns 4%. Delta Air Lines and Northwest don't earn anything because they don't earn any money.

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's stock.

Please note: 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 we will sometimes see a negative number for shareholders' equity. The danger here is that 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.

So here is the rule: High returns on shareholders' equity means "come play." Low returns on shareholders' equity mean "stay away."

Got it? Okay, let's move on.

Gross Profit Margin: Key numbers for Warren in his search for long-term gold.

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

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

2. Return (Profit) Test

GROSS PROFIT/GROSS PROFIT MARGIN: KEY NUMBERS FOR WARREN IN His SEARCH FOR LONG-TERM GOLD

  

Income Statement
($ in millions)
-> Revenue	$10,000
Cost of Goods Sold	3,000
-> Gross Profit	$7,000

    Gross Profit $7,000 / Revenue $10,000 = Gross Profit Margin 70%

Now if we subtract from the company's total revenue the amount reported as its Cost of Goods Sold, we get the company's reported Gross Profit. An example: total revenue of $10 million less cost of goods sold of $3 million equals a gross profit of $7 million.

        Gross profit is how much money the company made off of total revenue after subtracting the costs of the raw goods and the labor used to make the goods. It doesn't include such categories as sales and administrative costs, depreciation, and the interest costs of running the business.

By itself, gross profit tells us very little, but we can use this number to calculate the company's gross profit margin, which can tell us a lot about the economic nature of the company.

The equation for determining gross profit margin is:

Gross Profit / Total Revenues = Gross Profit Margin

Warren's perspective is to look for companies that have some kind of durable competitive advantage---businesses that he can profit from over the long run. What he has found is that companies that have excellent long-term economics working in their favor tend to have consistently higher gross profit margins than those that don't.

Let me show you:

The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include: Coca-Cola, which shows a consistent gross profit margin of 60% or better; the bond rating company Moody's, 73%; the Burlington Northern Santa Fe Railway, 61%; and the very chewable Wrigley Co., 51%.

Contrast these excellent businesses with several companies we know that have poor long-term economics, such as the in-and-out-of-bankruptcy United Airlines, which shows a gross profit margin of 14%; troubled auto maker General Motors, which comes in at a weak 21%; the once troubled, but now profitable U.S. Steel, at a not-so-strong 17%; and Goodyear Tyre---which runs in any weather, but in a bad economy is stuck at a not-very-impressive 20%.

In the tech world---a field Warren stays away from because he doesn't understand it---Microsoft shows a consistent gross profit margin of 79%, while Apple Inc. comes in at 33%. These percentages indicate that Microsoft produces better economics selling operating systems and software than Apple does selling hardware and services.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.

As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too). Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition. And a company in a fiercely competitive industry, without some kind of competitive advantage working in its favor, is never going to make us rich over the long run.

While the gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage. Warren strongly emphasizes the word "durable," and to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the "consistency" is there. Warren knows that when we look for companies with a durable competitive advantage, "consistency" is the name of the game.

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high interest costs on debt. Any one of these three costs can destroy the long-term economics of the business. These are called operating expenses, and they are the thorn in the side of every business.

RETAINED EARNINGS: Warren's secret for getting super-rich

RETAINED EARNINGS: WARREN'S SECRET FOR GETTING SUPERRICH

  

Balance Sheet/Shareholders' Equity
($ in millions)
Preferred Stock	$0
Common Stock	880
Additional Paid in Capital	7,378
-> Retained Earnings	36,235
Treasury Stock---Common	-23,375
Other Equity	626
Total Shareholders' Equity	$21,744

At the end of the day, 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 use, they can greatly improve the long-term economic picture of the business. It was Warren's policy of retaining 100% of Berkshire's net earnings that helped drive its shareholders' equity from $19 a share in 1965 to $78,000 a share in 2007.

To find the yearly net earnings that are going to be added to the company's retained earnings pool, we 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. In 2007 Coca-Cola had after-tax net earnings of $5.9 billion and paid out in dividends and stock buybacks $3.1 billion. This gave the company approximately $2.8 billion in earnings, which were added to the retained earnings pool.

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. Likewise, 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.

Out of all the numbers on a balance sheet that can help us determine whether the company has a durable competitive advantage, this is one of the most important. It is important in that if a company is not making additions to its retained earnings, it is not growing its net worth. If it not growing its net worth, it is unlikely to make any of us superrich 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. Let's check out a few of Warren's favorite companies with a durable competitive advantage: Coca-Cola has been growing its retained earnings pool for the last five years at an annual rate of 7.9%, Wrigley at a very chewy 10.9%, Burlington Northern Santa Fe Railway at a smoking 15.6%, Anheuser-Busch at a foamy 6.4%, Wells Fargo at a very bankable 14.2%, and Warren's very own Berkshire Hathaway at an outstanding 23%.

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. As an example, Procter & Gamble, in 2005, saw its retained earnings jump from $13 billion to $31 billion when it merged with The Gillette Co.

Even more interesting is the fact that both General Motors and Microsoft show negative retained earnings. 

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

One of the great secrets of Warren's success with Berkshire Hathaway is that he stopped its dividend payments the day that 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 theory is simple: 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, of course, that it has to keep buying companies that have a durable competitive advantage. Which is exactly what Warren has done with Berkshire Hathaway. Berkshire is like a goose that not only keeps laying golden eggs, but each one of those golden eggs hatches another goose with the golden touch, and those golden geese lay even more golden eggs. Warren has discovered that if you keep this process going on long enough, eventually you get to start counting your net worth in terms of billions, instead of just millions.

Total Assets and the Return on Total Assets

TOTAL ASSETS AND THE RETURN ON TOTAL ASSETS

  

Balance Sheet/Assets
($ in millions)
Total Current Assets	$12,005
Property/Plant/Equipment	8,493
Goodwill, Net	4,246
Intangibles, Net	7,863
Long-Term Investments	7,777
Other Long-Term Assets	2,675
Total Assets	$43,059

Add current assets to long-term assets, and we get the company's total assets. Its total assets will match its total liabilities, plus shareholders' equity. They balance with each other, which is why it is called a balance sheet.

Total assets are important in determining just how efficient the company is in putting its assets to use. To measure the company's efficiency, analysts have come up with the return on asset ratio, which is found by dividing net earnings by total assets.

Capital, however, always presents a barrier to entry into any industry, and 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. Coca-Cola has $43 billion in assets and a return on assets of 12%; Procter & Gamble has $143 billion in assets and a return on assets of 7%; and Altria Group, Inc., has $52 billion in assets and a return on assets of 24%. But a company like Moody's, which has $1.7 billion in assets, shows a 43% return on assets.

While many analysts argue that the higher the return on assets the better, Warren has discovered that really high returns on assets may indicate vulnerability in the durability of the company's competitive advantage. Raising $43 billion to take on Coca-Cola is an impossible task---it's not going to happen. But raising $1.7 billion to take on Moody's is within the realm of possibility. 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.

The lesson here is that sometimes more can actually mean less over the long-term.