Warren Buffett’s Financial Statement Rules of Thumb:
INCOME STATEMENT:1: Gross Margin
Equation: Gross Profit / Revenue
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
