No discussion on Financials is complete without a discussion on how the Oracle of Omaha analyzes the Income statement, balance sheet and cash flow statement. Of Graham's many students, Buffett is arguably the most successful...but just remember that first and foremost, we're talking about LOGICAL steps to analyzing companies. Beware of geeks bearing formulas. Buffett (and his partner Charlie Munger) really keep things simple & subtle. Balance sheet & Income statement analysis is like giving the company a "physical examination".
What Buffett Looks for on the Balance Sheet
The Balance Sheet shows the compamny's financial condition at a certain point in time. It shows how solvent the company is. It allows you to develop a better idea of how much the company is worth vs. what it owes.
1. Cash and Equivalents
One of the most important aspects of the Balance Sheet is liquidity - the amount of cash the company can dispose of in the short term. This provides flexibility.
When a company is suffering a short term problem, Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.
A high amount of Cash & Equiv. means generally that the company has a competitive advantage and/or is generating lots of cash via an asset sale (which is not always good). A low stockpile of cash usually means poor to mediocre economics.
Lots of cash and marketable securities, accompanied by a low amount of longer term debt, indicates that the business will sail on through tough times.
Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal how the cash was created.
2. Inventory
Tracking inventories/sales over 5yrs is also important to find out whether the company's product has decreased in popularity or whether it's still requested. Manufacturers with durable competitive advantages have the advantage that the products they sell do not change, and therefore will never become obsolete. Buffett likes this advantage.
When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.
3. Net Receivables
Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables. But if the company has a true competitive advantage, they will not need to cut corners on financing. Actually it would be quite the opposite: the companies that look best will get paid quickly and be able to delay payment as much as possible.
If a company consistently shows lower Net receivables/sales than competitors, then it usually has some kind of competitive advantage which requires further investigation.
3. Property, Plant & Equipment
A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must "replace to keep pace".
Generally speaking, a company with a solid competitive advantage can fnance new equipment through internal cash flows, whereas the no advantage company requires debt to finance.
Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures.
4. Goodwill
Buffett also says that whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. This can be a positive, if the company is buying businesses with durable competitive advantages.
So the first rule is to verify that Goodwill is rising because of acquisitions. But what if Goodwill remains the same? If goodwill stays the same, the company might be acquiring other companies at less than book value, or not acquiring at all. Businesses with competitive advantages never sell for less than book value.
5. Total Assets & Return on Total Assets
Buffett stated this much earlier than the fellows at Alpha Architect (sorry guys): Return on Assets, over time, measures how efficient the company is. Capital is a barrier to entry in many industries, so one of things that make a competitive advantage durable is the cost of assets needed to get in.
Buffett states that "really high" ROA may indicate vulnerability in the durability of the competitive advantage. Generally speaking, 5yr ROA higher than 7% is GOOD.
6. Current Liabilities
Includes accounts payable, accrued expenses, other current liabilities and short term debt. These liabilities are due within one year or less. Buffett generally stays away from companies that ‘roll over the debt’ When investing in financial institutions, Buffett prefers to see long term borrowing rather than short term borrowing.
A favorite financial holding of his, reported in the book, was Wells Fargo. It had 57 cents short term debt for every dollar of long term debt. Aggressive banks (like Bank of America) had $2.09 short term for every dollar of long term debt.
So of course, it's best to see 5yr current liabilities/long term debt low and stable.
7. Long Term Debt coming Due
Companies with durable comparable advantages need little or no long term debt to maintain operations. Too much debt coming due in a single year spooks investors and can offer attractive entry points if the company has a stable track record. However, too much debt leads to cash flow problems and potential bankruptcy because the interest payments on the load of debt tend to eat into the company's earnings.
Buffett says it well: little or no long term debt means a probably good long term bet.
8.Total Liabilities & Debt to Shareholders Equity Ratio
Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations. It should be obvious that companies with a competitive advantage will show higher levels of equity and lower levels of debt.
9. Retained Earnings: Buffett’s Secret
The analysis of Retained Earnings is one of the most important indicators of a durable competitive advantage. Net earnings can be paid out as dividends, used to buy back shares or retained for growth.
If the company loses more than it has accumulated, retained earnings is negative. If a company isn’t adding to its retained earnings, it isn’t growing its net worth. The rate of growth of retained earnings is good indicator of whether it’s benefiting from a competitive advantage or not.
What Buffett Looks for on the Income Statement
The income statement is the record of how much money the company made (or lost) in a ceratain period of time (revenues) and how much it paid out in order to conduct operations (expenses).
The key focus is to verify the quality of earnings reported: what is driving them and whether they have been stable or not over time. One of the things that market practitioners generally don't do is investigate 5-10 yrs of history, when comparing companies. Only if you know where you come from, can you get an idea of where you can get to...
1. Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins
GPM = (Revenue - Cost of Goods Sold)/Revenue
Why is a high - and stable - GPM important? The GPM can rise due to:
- an increase of goods sold
- an increase of prices
- a decrease of costs
Buffett believes that a company with a durable competitive advantage will have a high margin over time, because of the freedom to price in excess of cost, or to produce with a very efficient (lean) process, keeping costs low. The precise metrics he uses are:
5yr average greater than 40% = Company likely has a durable competitive advantage
5yr average less than 40% = competition is starting to erode margins
5yr average less than 20% = no sustainable competitive advantage
2. Sales Goods and Administration: these are all the fixed expenses like headquarters and employees. Of course, the lower the number, the better. Higher numbers would indicate bloated salaries or the inability to control expenses. Companies with no durable competitive advantage show wild variation in SG&A as percentage of gross profit:
SG&A/(Revenue - COGS)
The precise metrics he uses are:
- 5Yr average less than 30% is fantastic
- 5yr average close to 100% would indicate a highly competitive industry (so little competitive advantage, if any)
3. Interest Expenses/EBIT = Interest Expense/(revenue - Cogs - D&A)
Companies with high interest expenses relative to operating income tend to be either:
1) in a fiercely competitive industry where large capital expenditure is required to stay competitive
2) a company with excellent business economics that acquired a significant amount of debt
But as a general rule, companies with durable competitive advantages often carry little or no interest expense.Buffett's favorites in the consumer products category all have less than 15% of operating income. Also, be aware that interest expenses can vary widely between industries. Interest ratios can be very informative of the level of economic danger. In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.
4. Net Income = EBITDA --> EBITDA/Revenue
Just like before, we're looking for consistency and an upward long term trend. Durable competitive advantage companies report higher net earnings relative to total revenues. If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage. If net earnings is less than 10%, likely to be in a highly competitive business
What Buffett Looks for on theCash Flow Statement
Buffett's focus is entirely on the Capital Expenditures of the company (CAPEX). These are funds used by the company to acquire or upgrade physical assets such as property, industrial buildings or equipment. It is also used to undertake new projects or investments by the firm.
Capex = (Total Assets year 1 - total assets year 0) - (Total Liabilities Year 1 - Total liabilities Year 0)
Companies with durable competitive advantages use a smaller portion of earnings for capital expenditure for continuing operations than those without.
What Buffett suggests is to compare capex to net earnings. Add up total capex for 5yrs at least, and compare with total net earnings over the same period. If Capex is less than 50%, then the company might have a durable competitive advantage. If capex is than 25%, the company most likely has a competitive advantage.
BACKTESTING BUFFETT
So what would Buffett's criteria produce, if we screened for the above criteria? Using Portfolio123, and inputting the criteria easily available (yes, I'm still learning how to use Portfolio123), it is obvious how even looking properly at company financials, and rebalancing once per year can yield extaordinary results.
The man knows what he's talking about...after all, it's Warren Buffett people.
References:
Warren Buffett and the Interpretation of Financial Statements - Mary Buffett
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