For regular investors, understanding how Warren Buffett interprets financial statements is a great place to start when analysing what companies to invest in. While Warren Buffett's exact interpretation of financial statements is unknown, he has given a number of key pointers over the years, with regards to what he looks for when investing in firms.
Income Statement
- Gross Profit Margins: Buffett look for firms which have economic 'Moats' (Durable competitive advantages). Firms which are excellent performers in their respective industries tend to have much higher margins than their competitors.
- Gross Profit Margins of over 40%. Conversely, firms which have gross margins less than 20% usually tend to sell products which are commodities or extremely price sensitive. These firms usually lack a durable competitive advantage.
- Selling & General Administration expenses: Buffett aims to identify firms which spend less than 30% of their revenue on SG&A. This represents operational excellence and firms which tend to be best in class in their industries.
- Return on equity: Buffett identifies this as being one of the most important measures of a firm's ability to generate wealth for its shareholders over time. Buffett has regularly identified a 12% return on equity as being the average for public companies. Above 20% is good, while firms that earn above 30% are extraordinary.
- Return on invested capital: Buffett identifies how management is reinvesting the firm's retained earnings and how they are able to grow their earnings over time with funds earned in previous years. Firms earning more than 30% on re-invested capital are considered outstanding (reinvested capital are profits which the firm has earnt and directly reinvests into the business).
- Net earnings: Consistent upward trend in the firm's net earnings, with a consistency of performance over time and predictability in the firm's earning power.
Balance Sheet
- Debt levels: Buffett aims to identify firms with low levels of debt and is particularly wary of firms which have high-interest expenses. To Buffett, this may be a sign of a business that operates in a fiercely competitive industry or that the business is highly capital intensive
- Cash balance: Buffett looks for an ample buffer of cash/marketable securities which ensures that the business will sail through economic downturns.
- Inventories/Accounts receivable: Buffett identifies firms which increase their inventories and accounts receivable at the same pace which they increase their net earnings, demonstrating business efficiency.
- Property & Plant: Buffett aims to identify firms which are not constantly required to upgrade their facilities and have a consistent spend on property/plant. Firms which have high capital expenditures tend not to have a competitive advantage.
- Return on assets: Firms which generate high returns on their assets are demonstrating high levels of efficiency.
Takeaway for investors
The next time you try and analyse a business keep in mind some of the metrics that Warren Buffett looks for when analysing financial statements. Make sure that you are investing in companies which are best in class and have sustainable competitive advantages. Don't make the mistake that most investors make of simply investing in average businesses.
'Price is what you pay, value is what you get' – Benjamin Graham
