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Buffett on Financial Statements: The Income Statement

- By Robert Abbott

In the first section of "Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage", authors Mary Buffett and David Clark addressed the income statement, and the gems that Warren Buffett ( Trades , Portfolio ) found in them.


This statement is comprised of three elements:

  1. Revenue.
  2. Expenses.
  3. Profit (or net earnings), reached by subtracting expenses from revenue.



Warren Buffett Income Statement

Unlike his mentor and former employer, Benjamin Graham, Buffett took this statement very seriously. Graham and his contemporaries looked only at whether a profit existed or not. That would seem a natural perspective for investors taking a short-term view (Graham had a relatively short-term perspective, but long in comparison to most of his peers in the 1920s and 1930s). That's where Buffett began, but as we've seen, he later adopted a longer-term perspective; in many cases he has said he is investing "forever."

The amount of profit is important, especially if it is consistent, but Buffett found much more once he began studying income statements.

Revenue

Starting at the top, the first line is revenue, which always refers to gross or total revenue. In other words, every bit of money that came in from sales of products or services. It is an interesting number, but does not mean much by itself.

Cost of goods sold

Also known by the more descriptive term, cost of revenue, this is posted immediately below the revenue line and shows how much the company spent to earn the income listed on the revenue line. For example, a furniture store would calculate its cost of goods by starting with the cost of the inventory on hand at the start of the year, add inventory purchased during the year and subtract the cost of inventory at the end of the year.

Gross profit

As the screenshot above shows, the cost of goods sold is subtracted from revenue to reach gross profit. This number tells investors how much money the company made after taking out costs such as raw materials and labor; it does not include sales and administrative costs, depreciation or interest costs.

Gross profit margin

This is not shown on the actual income statement, but is derived from what we've seen above. It is calculated by dividing gross profit by revenue (total revenue) and shows as a percentage. It is a pivotal number for Buffett because it gives him a sense about a company's potential competitive advantage (or lack of one).

Generally speaking, "What he has found is that companies that have excellent long-term economics working in their favor tend to have consistently higher gross profit margins than those that don't." Consider how Buffett categorizes companies by their gross profit margins:

  • Durable advantages: Consistent gross profit margins of 40% or more; think of companies such as Coca-Cola (KO) at 60% and Moody's (MCO) at 73% (all figures as of 2007-08).
  • Modest advantages: Gross profit margins of 20% to 40%, consider Apple (APPL) at 33% then and 38% at the end of December 2018.
  • No competitive advantage: Gross profit margins of less than 20%, suggesting highly competitive circumstances. Examples from the book included United Continental (UAL) at 14%.



While such percentages offer preliminary indications of durability (or lack of it), they are not definitive. That's because of what may happen on the three lines below.

Operating Expenses

  1. Selling, general and administrative (SGA) costs, which include management compensation, advertising, payroll costs, etc. These costs can be quite high in some companies; Proctor & Gamble (PG), for example, was spending 61% of its gross profit on SGA costs when this book was written. Again, in looking at the numbers, Buffett wants to know how consistent they are over the previous 10 years.
  2. Research and development. The guru stays away from companies that need a lot of R&D spending. For example, Merck (MERCK) was spending 29% of its gross profit on R&D, while its SGA was 49%; as a result, 78% of its gross was committed from the start. The company might reduce its R&D, but that would mean an end to its competitive advantage. Buffett thinks companies that must spend a lot of R&D have an inherent flaw.
  3. Depreciation, amortization and non-operating, non-recurring expenses. Buffett discovered that companies with durable moats generally have lower depreciation costs as a percentage of gross profit than companies without a moat. Coca-Cola, for example, had a consistent depreciation rate of 6%, while General Motors (GM) had a depreciation rate that varied between 22% and 57% (GM operates a capital-intensive business).



Interest expense

Continuing down the income statement, we come to the cost of borrowing money, an expense Buffett likes to avoid. It is considered a financial cost rather an operating cost because it is not directly tied to a production or sales process. Durable companies usually pay little or no interest, more specifically, less than 15% of operating income. This rule of thumb does not apply to financial businesses such as Wells Fargo (WFC).

Gain or loss on sale of assets

If a company buys a building for $1 million, depreciates it down to $500,000 and then sells it for $800,000, it would show a gain of $300,000 on the asset. Or if the building sold for $400,000, then it would record a $100,000 loss.

Other

Much the same as gain or loss on sale of assets, but distinct because it includes non-operating assets, uncommon income or expense events, fixed assets, licensing agreements and the sale of patents. Because they are non-recurring events (and take away from consistency), Buffett takes them out of net earnings when considering whether there is a durable moat.

Income before tax

This is the number Buffett uses when calculating the return from buying a business, whether in whole or by buying a partial interest through shares. This allows an easier comparison with other companies because they are all sold on this basis. It also feeds into his idea that a company holding a durable competitive advantage is a type of "equity bond" that includes a growing coupon or interest rate.

Income taxes paid

The subheading of this chapter is "How Warren Knows Who is Telling the Truth," an acknowledgement that a company's tax bill will reflect its true pre-tax earnings. According to the authors, "Warren has learned over the years that companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well. The beauty of a company with a long-term competitive advantage is that it makes so much money it doesn't have to mislead anyone to look good."

Net earnings

At the end of the income statement, the "bottom line", comes net earnings, showing how much the company made after taxes. Buffett has two takes on this number. First, are net earnings growing consistently, is there an upward trend? The trend line need not be smooth, but it must be upward. Second, he is looking for a higher percentage of net earnings to total revenue. For example, Moody's was earning 31% on its total revenues, while Southwest Airlines (LUV) was earning 7%. Buffett believes a company reporting net earnings of 20% or more on total revenue is very likely in possession of a durable moat. Again, financial companies are exempt from this requirement.

That wraps up Buffett and Clark's review of the Oracle of Omaha's thinking about the income statement, and how he uses it to find outstanding companies with durable competitive advantages.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.