INCOME STATEMENT:
Equation: Gross Profit / Revenue
Buffett's Logic: Signals the company isn’t competing on price. 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. Equation: R&D Expense / Gross Profit Rule: 30% or lower Buffett's Logic: R&D expenses don't always create value for shareholders. 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. Equation: Interest Expense / Operating Income Rule: 15% or lower Buffett's Logic: Great businesses don’t need debt to finance themselves. 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. Equation: Net Income / Sales Rule: 20% or higher Buffett's Logic: Great companies convert 20% or more of their revenue into net income. Equation: Year 2 EPS / Year 1 EPS Rule: Positive & Growing Buffett's Logic: Great companies increase profits every year.
BALANCE SHEET: Equation: Cash > Debt Rule: More cash than debt Buffett's Logic: Great companies don't need debt to fund themselves. Equation: Cash > Debt Rule: More cash than debt Buffett's Logic: Great companies generate lots of cash without needing much debt. Equation: Total Liabilities / Shareholder Equity + Treasury Stock Rule : < 0.80 Buffett's Logic: Great companies finance themselves with equity. Rule: None Buffett's Logic: Great companies don't need to fund themselves with preferred stock. Equation: Year 1 / Year 2 Rule: Consistent growth Buffett's Logic: Great companies grow retained earnings each year. Rule: Exists Buffett's Logic: Great companies repurchase their stock.
CASH FLOW STATEMENT: Equation: Capex / Net Income Rule: <25% Buffett's Logic: Great companies don't need much equipment to generate profits.
There are plenty of exceptions to these rules.
CONSISTENCY IS KEY!Warren Buffett's Financial Statement Analysis Rules for identifying Great businesses with a Durable Competitive Advantage
Here is a summary on Warren Buffett's financial statement rules of thumb for identifying great businesses with a durable competitive advantage.
Executive Summary
The article distills Warren Buffett's approach to analyzing financial statements into a set of key metrics. The core philosophy is that great, "wide-moat" businesses possess a durable competitive advantage, which manifests as consistent, superior profitability, strong financial health, and robust cash generation with minimal ongoing capital requirements. The ultimate caveat is that consistency in these metrics is more important than any single year's data.
Key Financial Statement Rules of Thumb
Here is a condensed overview of the rules, organized by financial statement:
💰 Income Statement (Focus: High & Efficient Profitability)
High Gross Margin (≥40%): Indicates pricing power and that the company isn't competing on price.
Low SG&A & R&D Margin (≤30%): Suggests the business is efficient and doesn't require heavy overhead or constant reinvestment in R&D to maintain its position.
Low Depreciation & Interest Margin (≤10% and ≤15%): Signals the company isn't burdened by heavy investment in depreciating assets or reliant on debt to operate.
High Net Margin (≥20%): The bottom-line proof of a great business, converting a significant portion of revenue into profit.
Consistent EPS Growth: Shows a track record of increasing shareholder profits year after year.
⚖️ Balance Sheet (Focus: Financial Strength & Self-Funding)
Strong Cash Position (Cash > Debt): The company is a net generator of cash and isn't reliant on debt for funding.
Low Adjusted Debt-to-Equity (<0.80): Prefers companies financed primarily through equity and retained earnings rather than liabilities.
No Preferred Stock & Growing Retained Earnings: Avoids complex financing and favors companies that can consistently grow their reinvested profits.
Treasury Stock Exists: Indicates that the company is shareholder-friendly and uses excess cash to buy back shares.
💸 Cash Flow Statement (Focus: Strong Cash Generation & Low Capital Intensity)
Low Capex Margin (<25% of Net Income): The business does not require significant ongoing capital investment to maintain its profits.
****Strong Free Cash Flow (FCF): This is a crucial addition. Free Cash Flow is calculated as Operating Cash Flow minus Capital Expenditures. It represents the cash a company generates after funding the operations and maintenance of its assets. For a great business:
FCF should be consistently positive and growing.
It should represent a high conversion of Net Income into cash (e.g., a high FCF-to-Net Income ratio).
Buffett's Logic: Abundant and growing FCF is the lifeblood of a durable company. It provides the flexibility to fund new opportunities, pay dividends, buy back stock, and pay down debt without relying on external financing. It is the ultimate validation of a company's profitability and financial health.
Key Takeaway
These rules form a checklist to identify companies that are highly profitable, financially robust, and are powerful cash-generating machines. By consistently meeting these criteria—especially generating strong Free Cash Flow with low capital demands—a company demonstrates the hallmarks of the "durable competitive advantage" that Warren Buffett famously seeks.
