Warren Buffett and the Interpretation of Financial Statements Summary provides a free book summary, key takeaways, review, top quotes, author biography and other vital points of Mary Buffett and David Clark’s book. It helps you to learn the way Warren Buffett finds the best stocks. He does this by taking hints from financial statements.

Financial statements have signs about a firm’s future performance. Warren Buffett is on a constant search for such cues. And, this has placed him among the list of world’s wealthiest people. Hence, seeing how he interprets financial statements is very helpful. He computes appropriate ratios from the financial records. Then he uses these ratios to identify the most promising firms. Beginners can learn the most from this book Warren Buffett and the Interpretation of Financial Statements. But, the writers include smart tips for even experienced investors. We recommend it for readers wanting a basic knowledge of financial records analysis. Also, for people who wish to learn how Buffett chooses his investments, it’s a must-read.

“Warren [Buffett] has learned that time will make him superrich when he invests in a company that has a durable competitive advantage working in its favor.”

This Summary Will Help You Learn

How Warren Buffett uses financial records to find great firms,

What he seeks three kinds of financial statements, and

Why he gives particular focus to some ratios.

Take-Aways

Buffett invests in high-grade firms having a strong competitive edge.

He likes businesses whose products/services are unique. Or businesses which sell their products/services at the lowest price.

Cash flow and income statements and balance sheets show a company’s potential.

Firms having steady net incomes at 20%≥ of revenues are industry leaders.

Don’t invest in firms having high expenses for interest, research, and depreciation.

Firms with a strong cash position and little outside debt pass troubled times easily.

Buffett likes firms which create retained earnings.

He has $64bn in unrealized capital gains. These gains are on shares he owns in Berkshire Hathaway.

Buffett views shares as “equity-bonds” with growing “yields.”

Think of selling any share whose price is 40 times more than its EPS.

Suggested Reading: Good to Great Summary: Jim Collins

Suggested Reading: In Search of Excellence Summary: Thomas Peters and Robert Waterman

Warren Buffett and the Interpretation of Financial Statements Summary

The Divergent Styles of Warren Buffett and His Mentor

During the 1950s, Benjamin Graham was Warren Buffett’s mentor. Graham was a professional investor and economist. He believed in value investing. That is, buying firms having low share prices. Buffett was Graham’s pupil at Columbia University, New York. He then later went on to work for Graham’s investment firm.

When he began his own business, Buffett changed Graham’s technique in many ways. For example, Buffett unfollowed Graham’s rule to sell shares once they increase by 50%. It’s because at times their prices can rise even more. Graham used to buy stocks by its cost. That is, the lower, the better. But, Buffett prefers high-grade firms with steady cash-flows. So, he’s used to paying a fair price for their stocks. This need not be the lowest price. Graham believed in the importance of keeping a diverse stock portfolio. This increased the chances of well-performing stocks to balance losers. In contrast, Buffett favors a portfolio focusing on a few stocks. And, these few stocks are the best investments available as per him.

Buffett analyses firms’ financial statements. This helps him to distinguish great ones from the rest. As per him, great firms have some financial features. He only invests in financially stable firms. These companies have a definite competitive edge in the market. Such advantage leads to a monopoly-like situation. And this, in turn, allows them to sell more or charge more.

Three Business Models That Buffett Likes Best

The firms which appeal to Buffett have one of the three business frameworks. They either sell a unique service or a unique product. Or, they’re low-cost seller and buyer of a good/service the consumers continuously need. Companies selling unique goods include Coca-Cola, Hershey, and Budweiser. Many other firms also sell soda, chocolate, and beer. But, they don’t have the brand power of Coke, Hershey’s and Bud. Companies will sell unique services include Wells Fargo, Moody’s Corp., and H&R Block Inc. Costco and Walmart have a third business model. That is, they’re low-cost providers of staple things like clothing and food. Buffett prefers these brands because they rule a part of the customer’s mind.

Hunting for Value in Financial Statements

To learn about a company, Buffett reads three kinds of financial statements. These are the cash flow statement, income statement, and balance sheet. He analyses these records separately and together. And then he predicts the future of a firm plus its share value.

The income statement is prepared yearly and quarterly. It summarizes operating costs, revenues, net results, and overhead expenses. The cash flow statement presents cash consumed or provided by three activities. These are investments, operations, and financing activities. In contrast, the balance sheet shows a company’s condition at one point. It summarizes the position of liabilities and asset for a given period. Buffett checks many line items in these statements. He then analyses the company’s strengths and weaknesses. For example, he deducts the COGS from revenue to get gross profit (GP). Then he divides GP by revenue to find the GP margin. A company which steadily gets margins of 40% has a keen competitive edge.

A firm’s operating activities produce their selling, general and admin (SGA) expenses. These include legal costs, executive salaries and advertising fees. SGA expenses alone don’t offer too much information about a company’s future. Analysis of line items is most instructive. For example, Buffett sees the percentage of GP such expenses eat. Firms have stable SGAs as a proportion of GP often have principal places. As a general rule, anything below 30% is said to be great.

The Burden of Research, Depreciation and Interest Expenses

Buffett doesn’t invest in firms having significant commitments to R&D. Instead, he favors firms like Coca-Cola that uses the same secret-formula. And, it still is the industry leader. In some sectors, like IT, R&D is a crucial source of competitive edge. But, technology changes are very fast in this industry. Hence, any advantage of a research innovation will be temporary. Consider the R&D pressures of GM & Wrigley. GM should continuously invest in R&D for making new vehicles. Or else, it will lose its market share.

Wrigley sells the same famous brand of gums for years now. So, which firm sounds like a better investment? Suppose a person bought $100,000 shares of both firms in 1990. By 2008, he’d have GM stocks worth $97,000. In contrast, his Wrigley stocks would be worth $547,000. Buffett doesn’t like high-interest expenses and depreciation either. Instead, he prefers investing in firms having low depreciation expenses relative to GP. Same way, he seeks companies with the lowest yearly interest expenses relative to GP. Because of the less interest payment, the less the firm’s debt.

Suggested Reading: Absolute Returns Summary: Alexander M. Ineichen

Suggested Reading: Start with Why Summary: Simon Sinek

Rating Companies by Their Returns on Revenue

Profitable firms use a simple formula to find their earnings per share. It is:

EPS = Net income / Number of common shares outstanding

Security analysts around the world use this metric. But, Buffett focuses more on net income when analyzing firms. He determines a company’s return on revenue. This he does by dividing net income by revenue. Return on revenue helps him to analyze the company’s competitive position. If this percentage is steadily more than 20%, the firm often has a lasting advantage. Many firms have returned from 10-20%. And few of them denote long-run investment mine which people haven’t found yet.

The Asset Side of the Balance Sheet

The balance sheet presents a company’s assets, liabilities and shareholder’s equity. This equity is equal to total assets minus total liabilities. These three elements give crucial information about a company’s potential. Current assets cover liquid investments, cash, accounts receivables, and inventory. These’re items which the company can change into cash in a year. Such working assets and their sums differ based on the firm’s daily operations. For example, cash vis-à-vis accounts receivable may swing with changes in the business environment. Plant, property, and equipment are non-current assets. These also include intangibles like patents, franchises, and copyrights.

Buffett prefers a substantial cash and liquid asset position with low outside debt. Such businesses often sail on through tough times. Buffett even computes the net sum of accounts receivables. This is receivable sans bad-debts as a proportion of sales revenue. Firms with lower percentage often lead their industry.

The Liability Side of the Balance Sheet

Current liabilities mean debts which company has to pay in a year. These cover short-term loans, due expenses and accounts payable. Other groups of obligations are a long-run debt payable in more than a year. Firms with a lasting advantage over their peers produce enough money internally. This prevents the need to amass vast sums of long-term debt.

Company’s liquidity is calculated as a ratio of current assets to current liabilities. This is the current ratio. In traditional analysis, a ratio of more than 1 represents good liquidity. But, as per Buffett, some firms with a competitive edge have lower ratios. This’s because their strong businesses don’t need a massive cushion against insolvency. Buffett uses the same explanation for the debt-to-equity ratio. Some leading firms have higher debt-to-equity ratios. It’s because they consume a large part of their net income to pay dividends. Or to rebuy stocks. These uses of earnings impact the growth of stockholder’s equity. But, neither shows that a firm is facing high rival pressure.

The Magic of Retained Earnings

Retained earnings denote net income which a firm reinvests for its operations. Hence, in this case, the company doesn’t rebuy shares or pay dividends. Retained earnings are a part of stockholders’ equity in the balance sheet. Shareholders’ equity grows when retained earnings accumulate. Buffett feels firms with high retained earnings have a lasting edge over rivals.

He runs an investment holding firm “Berkshire Hathaway.” This publicly traded firm doesn’t pay any dividends. Such a policy has helped the firm amass vast amounts of retained earnings. This adds to long-term growth in the company’s value. Buffett favors rebuying stocks to paying dividends. This is his way of rewarding the shareholders. When it buys-back its shares, the firm increases its EPS. And as EPS grows, the share price also increases.

The tax charge is another significant factor. If Buffett got dividends on his company’s share, he’d need to pay income tax. Instead, he collects capital gains on his shares tax-free as-long-as he keeps the shares. Already, he has amassed $64bn of unrealized capital gains on his firm’s shares. And he hasn’t paid any tax on such paper gains.

“The place that Warren goes to discover whether or not the company has a ‘durable’ competitive advantage is its financial statements.”

Buying, Holding and Selling “Equity Bonds”

Berkshire invests long-term in firms with strong competitive edges. Hence, it owns shares which act as bonds with returns which increase over-time. Buffett names such shares “equity bonds.” The return on such a bond is the firm’s EPS. And as EPS increases with time, so does the return on the equity bond. For example. In the late 1980s, Buffett bought shares in Coca-Cola. He bought these for $6.50 per share. At this time, the firm had yearly earnings of 46 cents/share. This, for Buffett, equated to an initial return rate of 7%. By 2007, Coke was earning $2.57/share. This meant a 39.9% return on his initial investment.

Buffett invests long-term in firms having a lasting competitive edge. It’s because the longer one holds them, the better they do. But, three kinds of situations make selling a good share worth it. First, if sale proceeds can finance a better investment. Second, if the firm is giving up its competitive edge. And, third if the share price increases in an over-active bull market. If the share price is 40 times greater than yearly EPS, sell it. But, don’t buy another stock trading at 40 times its EPS. Instead, keep this cash and wait for the market to settle down. Wait till good equity bonds become available at low prices.

Yes, Buffett’s investing style needs patience. But the payoff is remarkable.

Suggested Reading: Unshakeable Summary: Tony Robbins

Suggested Reading: One Up On Wall Street Summary: Peter Lynch

Warren Buffett and the Interpretation of Financial Statements Review

Mary Buffet and David Clark provided the full summary of all the key points related to the financial statements and future performance of the firm in their summary of Warren Buffett and the interpretation of financial statements. The book was really helpful for the beginners, and they have the opportunity to learn about the financial records, computed ratios, and smart tips for the investment. The durable competitive advantage can be generated through the investment strategy and become a great fortune for the investor. The objective of the book was to make the reader able to learn about income statement, balance sheets, and cash flow statement with a precise explanation. We had found some interesting points when we were reading the book. The book showed durable competitive advantages and some hidden treasures were unearthed by the author. The factual learning was great about novice investors and traders.

The book elaborated competition in the business and strength of financial statement for the reader. The conclusive points were secretly discussed so the reader cannot reach to gems, but in fact, he is required to understand the lines mentioned in the book. Both authors inspired me by interpretation of all the quotes, anecdotes, and financial statements. Being a potential reader We discovered the effect of development cost as it becomes dangerous if the company keeps it as debt. The selling prices can be low for the company as Buffett explained, but the identification of perfect investor in the business is crucial. In the book, Buffett preferred firms of high grade along with the steady cash flows and focus of his portfolio was on the few stocks. We were reading the book and found the significant fact for the tax charges and income tax that was quoted by Buffet as, “the place that Warren goes to discover whether or not the company has a ‘durable’ competitive advantage is its financial statements.”

Warren Buffett and the Interpretation of Financial Statements Quotes

“Warren [Buffett] has learned that time will make him superrich when he invests in a company that has a durable competitive advantage working in its favor.”

“The place that Warren goes to discover whether or not the company has a ‘durable’ competitive advantage is its financial statements.”

“When Warren is looking at a company’s financial statement, he is looking for consistency.”

“Warren knows that one of the great secrets to making more money is spending less money.”

“Warren has learned over the years that companies that are busy misleading the IRS are usually hard at work misleading their share­hold­ers as well.”

“While the total revenue number alone tells us very little about the economics of the business, its ratio to net earnings can tell us a lot.”

“Making chewing gum is a much better and a far more profitable business for share­hold­ers than making cars.”

“In the business world, durability of a competitive advantage is a lot like virginity – easier to protect than it is to get back. ”

“The rule here is simple: Little or No Long-Term Debt Often Means a Good Long-Term Bet.”

“Finding what one is looking for is always a good thing, especially if one is looking to get rich.”

“Oc­ca­sion­ally even a company with a durable competitive advantage can screw up and do something stupid… Think New Coke.”

“To get rich, we first have to make money, and it helps if we can make lots of money.”

“Some men read Playboy. I read annual reports.” (Warren Buffett)

About the Authors

Mary Buffett and David Clark wrote four more books on how Warren Buffett decides his investments. Mary, a speaker, and the author was also Buffett’s daughter-in-law from 1981-1993. Clark is a managing partner at a private investment firm.

Feedback

After reading this Warren Buffett and the Interpretation of Financial Statements Summary, do you have any comment on it? We are looking forward to hearing from you! Please feel free to share your thought with us.

Suggested Reading: How to Pick Stocks Like Warren Buffett Summary: Timothy Vick

Suggested Reading: The Real Warren Buffett Summary: James O’Loughlin