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