Definitions:

10Qs: Quarterly financial statements.

10K: Annual report.

Short vs. long term liabilities: 1 year is the cutoff.

Current assets: cash or can be converted to cash in less

than a year.

This summary only includes the parts of the book about

interpretation of financial statements. The last part of the
book about Warren’s Buffett’s method of valuing
companies is in itself a huge topic, which I’ll summarize
later.

When Warren Buffett selects a company, one of the most

important factors he studies is having a durable
competitive advantage. To assess competitive
advantage, he studies financial statements. A company
should have one of the following to have durable
competitive advantage:

 Unique product.

 Unique service.

 A product/service that’s consistently needed.

  A product that it buys and sells at low prices.

The income statement:

Revenue is the money that comes in.

Gross profit = revenue — costs of good sold

Gross profit margin (%) = gross profit / revenue * 100

Operating profit = gross profit — operating expenses

Gain (loss) on sales of assets = the asset’s sales price —

the asset’s value on the books

Income before tax = operating profit — (interest expenses

+ sale assets + others)

Net earnings = income before tax — income tax

Per-share earnings = net earnings / number of shares

Gross profit margin:

 Higher gross profit margin is consistently associated
with excellent long-term outcomes.

 A high gross profit margin is created by the

company’s durable competitive advantage.
  Examples of good gross profit margin: Coca-Cola
(60%), Moody’s (73%), Wrigley (51%).

 Examples of bad gross profit margins: United Airlines

(14%), General Motors (21%), Goodyear Tire (20%).

 Companies with high operating expenses can lead to

bad future despite good gross profit margin.

Operating expenses:
Operating expenses include research and development,
selling and administrative costs, depreciation…etc.

 Selling, general and adminstrative expenses

(SGA):

‘SGA/gross profit’ ratio can vary between companies (25%

for Moody’s and 59% for Coca-cola).

Consistency is key.

Changes in this ratio are a bad sign (Ford from 89% to

780% or GM from 23% to 83%). Changes in the ratio can
be caused by decreased sales, leading to decreased
revenue with the same SGA.

 Research and development (R&D):

The continuous need for high costs of R&D is an indicator
of potential loss of competitive advantage.

Examples include Intel that spends 30% of its gross profit

on R&D.

Another examples is Coca-Cola that does not have any

significant R&D costs, despite very high SGA costs due to
advertising.

 Depreciation:

Depreciation is a REAL expense and MUST be included.

Be wary of companies hide depreciation to artificially

increase earnings.

Lower depreciation rates is associated with better

competitive advantage.

Examples of low depreciation costs to gross profit include

Coca-Cola (6%), Wrigley’s (7%).

Examples of high depreciation costs to gross profit include

GM (22–57%).

Financial costs (interest):

  It’s isolated on its own because it’s not associated
with any production or sales activities.

 Little or no interest expenses are a good indicator of

companies with competitive advantage.

 Examples of good interest to operating income ratio

include Proctor and Gamble (8%), Wrigley (7%),
Southwest airlines (9%).

 High interest payments relative to operating income is

often associated with one of the following:

1) Low competitive advantage of the company.

2) The company was bought in a leveraged buyout.

 Examples of high interest to operating income ratio

include Goodyear (49%), United airlines (61%)
American airlines (92%).

Net earnings:
 Net earning for a single year is useless.

 Long-term upward trend of net earnings is an

indicator of the durability of the competitive
advantage.
  Distinguish between historical net earnings and
historical per-share earnings. Share repurchases
programs can affect per-share earnings.

 A company with competitive advantage will have a

higher net earnings to total revenue ratio than other
competitors. This ratio is more important than
absolute net earnings.

 Examples of high ratio include Coca-Cola (21%),

Moody’s (31%).

 Examples of low ratio include Southwest airlines (7%),

GM (3%). Note than both suffer from lousy economics
because of the super competition in these fields.

Per-share earnings:
 Similar to net earnings, a single per-share earning
is useless. Look at 10 years.

 A 10-year upward trend of per-share earnings is an

indicator of the durability of the competitive
advantage.

 Stock buybacks leads to increased per-share earnings.

 Fluctuating demand and high competition lead to

fluctuating and unstable earnings.

The balance sheet:

Assets - liabilities = net worth (or shareholders’ equity)
Current asset cycle: Cash ⇒ inventory ⇒ accounts
receivable ⇒ cash

Net receivable = Total receivables - an estimation of bad

debts

Total current assets = cash and cash equivalent +

inventory + net receivables + prepaid expenses + other
current assets

The current ratio = current assets / current liabilities

Total assets = Total current assets + total long-term assets

Return on assets = Net earnings / total assets

Total current liabilities = accounts payable + accrued

expenses + short-term debt + long-term debt due + other
current liabilities

Total liabilities = total current liabilities + total long-term

liabilities

Shareholders’ equity = total assets- total liabilities

Shareholders’ equity = preferred and common stocks +

pain in capital + retained earnings - treasury stocks
Debt to shareholders’ equity ratio = total liabilities /
shareholders’ equity

Retained earnings = After-tax net earnings — (costs of

dividends + costs of buying back stocks)

Return on shareholders’ equity = net earnings /

shareholders’ equity

Current assets:
Cash and cash equivalents:

 A company with a lot of cash isn’t necessarily doing

well. The cash may be from selling assets or bonds.

 During a short-term business problem (causing the

stock to go down), a company with a lot of cash and
marketable securities and little or no debt is likely to
survive the hard times.

 a company with a lot of debt and low cash is a sinking

ship.

 As always, one year is useless. Study 7 years.

Inventory:

 Companies with inventory that is unlikely to go

obsolete are preferred.
  A good indicator of companies with durable
competitive advantage is a parallel rise in both
inventory and net earnings. This means that the
company is finding more ways to increase sales, and
is able to increase inventory to fulfil the demand.

 Companies with no competitive advantage will show

years of rapid increasing inventory followed by rapid
decreases.

Net receivables:

 Receivables is cash that will come to the company in

the near future.

 Since some debts will never be paid, net receivables

are receivables after deducting an estimation of bad
debts .

 On its own, net receivables amount may not tell a lot.

However, comparing it with competing businesses in
the same field is helpful.

 Companies with relatively lower net receivables to

gross sales than competitors are usually the ones
with high competitive advantage, eliminating their
need to market their products by offering financing.

Total current assets:

  This number is key to determining the ability of the
company to meet its short-term obligations.

 Traditionally, analysts have argue that good

companies must always have a current ratio (current
assets/current liabilities) that is higher than 1.

 Counterintuitively, many companies with durable

competitive advantage have a current ratio that’s
lower than 1.

 Examples of this includes Moody’s (0.64), Coca-cola

(0.95), Proctor & Gamble (0.82).

 This is explained as these companies have strong

earning power making it easy to cover current
liabilities. In such cases, the current ratio is useless.

Long-term assets:
Property, plant, and equipment:

 Carried on book as original costs less accumulated

depreciation.

 These become ongoing expenses in companies with no

competitive advantage due to the continuous need of
upgrades before wear-out.

 Companies with durable competitive advantage do not

need constant upgrades.
  Look at how this is financed! Companies with durable
competitive advantage can finance this internally
without the need for debt.

Goodwill:

 When company A buys company B for higher than the

book value of B, goodwill is the difference between
the real and paid values of B.

 Increasing goodwill indicates the continuous

acquisition of other businesses.

 Companies with durable competitive advantage

almost always sell with a value higher than books.

Intangible assets:

 These include patents, copyrights, trademarks,

franchises, brand names…etc.

 Internally developed intangible assets CANNOT be

carried on the balance sheet. Only intangible assets
acquired from a third-party are carried.

 The names of many companies with durable

competitive advantages like Coca-cola, Walmart,
Pepsi…etc. thus cannot be carried on balance sheets
despite being worth billions.
  The internally developed brand name (like Coca-Cola),
can thus be considered a hidden value carrier that
many investors don’t see early.

Long-term investments:

 Can be internal or external investments.

 It MUST be carried on the balance sheet as whichever

is lower: books cost or market price. It cannot be
marked higher even if it appreciates. This can be
a hidden value.

 External long-term investments tell us about the

company’s mindset.

Total assets:
 The return on total assets is an important measure of
the efficiency of the company.

 On the other hand, high costs can be an entry barrier

for new competitors. Such companies can maintain
competitive advantage (difficult for competitors to
enter) while also having relatively lower return on
assets (because of high value of assets).

 Examples include Coca-cola ($43 billion assets and

12% return) and Proctor & Gamble ($143 billion
assets and 7% return).
  This means that very high returns on total assets can
sometimes indicate vulnerability in the competitive
advantage, because of the easiness of competitors to
enter.

 Examples include Moody’s ($1.7 billion in assets and

43% return).

Current liabilities:
Accounts payable, accrued expenses, and other
current liabilities:

 Accounts payable is money owed to suppliers for

which the company got the invoice but hasn’t paid
yet.

 Accrued expenses is money that has yet to be invoiced

for. It includes sales tax payable, wages payable, and
accrued rent payable.

Short-term debts:

 Short-term money historically has been cheaper than

long-term money.

 An investing strategy is to borrow short-term money

and lend it at a higher interest. Then keep rolling
over the debt with short-term debts. Risks associated
with this strategy include the increase in short-term
 interest rates, and the inability to get more short-
term debts. Think Bear Stearns (and many other
banks) in the great recession.

 Examples include Bank of America which has $2.09 of

short-term debt for every dollar of long-term debt.

 A safer, but harder, strategy is to borrow long-term

and lend long-term.

 Examples include Wells Fargo which has 57 cents of

short-term debt for every dollar of long-term debt.

 These institutions are more durable and less

vulnerable to sudden shifts.

Long-term debt coming due:

 It’s the portion of the long-term debt that needs to be

paid in the current year.

 Adding this to short-term debts creates the illusion of

higher short-term debt.

 A company that always has a lot of long-term debt

coming due, probably lacks competitive advantage,
and is at risk of bankruptcy.

 A company with a single bad event leading to too

much long-term debt in the years ahead, may be
bought at a discount.
Long-term liabilities:
Long-term debt:

 Companies that have a durable competitive advantage

have little or no long-term debt.

 Look at the long-term debt load that the company has

been carrying for the last 10 years.

 A good company generally has enough yearly net

earnings to pay off all of its long-term debts within 3–
4 years.

 Moody’s and Coca-cola can pay all their long-term

debts in a single year using net earnings.

 Net earnings of GM and Ford for 10 years are not

enough to pay their long-term debts.

Deferred income tax, minority interest, and other

liabilities:

 Deferred income tax is tax that’s due but not paid yet.

 When company A acquires 80% or more of company

B, company A has the right to add 100% of company
B’s income and assets to its books. Minority interest
is the value of the remaining of company B that
company A does not own.
Total liabilities:
 Theoretically, well-performing companies should have
a lower debt to shareholders’ equity ratio (meaning
less debt).

 On the other hand, many great companies with

curable competitive advantage do not need large
equity and retained earnings, leading also to having a
relatively high debt to shareholders’ equity.

 Another important factor is the buyback of stocks

which can lead to higher ratio because of lower
shareholders’ equity.

 Examples of this include Moody’s. Before adjusting for

stocks buybacks, Moody’s has a relatively high debt
to shareholders’ equity ratio. However, after
adjustment, the ratio goes down to 0.63.

 Examples of companies performing bad include

Goodyear tire (adjusted ratio 4.35) and Ford
(adjusted ratio 38).

 These rules do not apply to financial institutions

(banks).

Shareholder’s equity/book value:

Stocks par value: the value of the stocks in the company’s
charter.
Preferred and common stocks:

 Common stock owners have the right to elect a board

of directors. They may receive dividends.

 Preferred stocks receive dividends and have the

priority to get paid if the company goes bankrupt.

 The term ‘paid in capital’ refers to the excess money

paid above the par value when the stock was sold.

 Many companies with durable competitive advantage

issue few or no preferred stocks. The reason is that
these stocks require expensive dividend payment that
cannot be deducted from taxes (in contrast to taking
a debt with a deductible interest).

Retained earnings:

 This is one of the most important indicators of durable

competitive advantage.

 It’s the earnings that are kept in the company to

improve it, and not paid as dividends or stocks
buyback.

 It’s an accumulative number; new retained earnings

are added to previous total.

 Examples of companies with good rate of growth of

retained earnings over 5 years include Coca-cola
 (7.9% annually), Wrigley (10.9% annually), Berkshire
Hathaway (23% annually).

 Some times an increase in retained net earnings can

be due to an acquisition.

 GM has negative retained earnings because of poor

economics,

 Microsoft has negative retained earnings because of

dividend payments and stocks buyback.

Treasury stocks:

 When a company buys back stocks, they are either

cancelled, or kept as treasury stocks (until being re-
issued again).

 Treasury stocks do not have voting rights and do not

receive dividends.

 Despite being an asset, they lower the shareholders’

equity and are carried as a negative on the balance
sheet.

 More treasury stocks ⇒ less company’s equity ⇒

higher return on equity (financial engineering)

 Companies with durable competitive advantage have

treasury stocks.
  Due the possibility of financial engineering mentioned
above, it’s important to determine the cause of
increases in return on equity and adjust for financial
engineering effects to determine the increase in
return on equity resulting from good economics. To
do this:

 Add the value of treasury stocks (as a positive

number) to the shareholders’ equity to get total
shareholders’ equity.

 Divide the company’s net earnings by the new

(positive) total shareholder’s equity.

 The resulting number will be the return of equity not

resulting from financial engineering.

Return on shareholders’ equity:

 Intuitively, companies with durable competitive

advantage have higher than average returns on
shareholders’ equity.

 Examples include Coca-cola (30%), Wrigley (24%),

Hershey’s (33%), Pepsi (34%), in contrast to
American airlines (4%).

The cash flow statement:

Similar to income statements, cash flow statements cover a
period of time.
A company can have a lot of cash and not profitable, and
vice versa.

Cash flow from operating activities = net income +

depreciation + amortization

Cash flow from investing operations = capital expenditures

(always negative) + other investing operations (negative or
positive)

Cash flow from financing activities = dividends paid +

issuance or retirement of stocks + issuance or retirement
of bonds

Net change in cash = cash flow from operating activities +

cash flow from investing operations + cash flow from
financing activities

Capital expenditures:
 Cash spent on assets that are expensed over more
than a year through depreciation or amortization
(property, plant, equipment, patents…etc.).

 Example: a truck is a capital expenditure, but gas is a

current expense.

 Capital expenditures to earnings ratio is generally

smaller in companies with a durable competitive
advantage.
  Examples include Coca-cola (19%), Wrigley (49%),
Moody’s (5%), in contrast to GM (444%), Goodyear
(950%).

Key points when studying a company:

Note that all these are rules that can have exceptions.

The income statement:

 Gross profit margin ≥ 40% and avoid high operating
expenses.

 Consistent ‘SGA/gross profit’ ratio.

 SGA/gross profit ratio < 30% is fantastic, but there

are good companies with a ratio up to 80%.

 Low (or non continuous) R&D costs.

 Low depreciation to gross profit ratio.

 Interest payouts ≤ 15% of operating income.

 Make sure the company’s reported income is

consistent with the tax they paid (find on SEC).

 Historical net earnings/total revenue ratio ≥ 20%.

Never less than 10%.

 10-year upward trend of net earnings and per-share

earnings.

The balance sheet:

 A lot of current cash and low debt for at least 7 years.

 Inventory that is rising consistently and in parallel

with net earnings.

 Lower net receivables/gross sales ratio than

competitors.

 Current ratio > 1. Exceptions include companies with

strong earning power.

 No ongoing increases in property, plant, and

equipment.

 When assessing return on total assets, keep in mind

that it sometimes as it gets higher, it indicates a
lower competitive advantage.

 Low or no long-term debt. Net earnings enough to pay

all long-term debt in 3–4 years.

 Debts to shareholders’ equity ≤ 0.8

 Absence of preferred stocks.

 Annually growing retained net earnings.

 The presence of treasury stocks and a history of

buying back shares.

 High returns on shareholders’ equity.

 AVOID businesses that use a lot of leverage to

generate earnings.
The cashflow statement:
 Positive cashflow.

 Capital expenditures/net earnings ≤ 25% for 10 years.

Never more than 50%.

 A history of buying back stocks.