Warren Buffet's Financial Analysis Guide for Rocket Stocks

**Lambo** · 06-06-2009 04:50 AM

I recently read Warren Buffets stock analysis book. It pretty much tells you how to analyze a firms financial statements, and what to look for if you want to invest in firms that have a solid competitive advantage.

So I figured if i want to learn how to analyze a firm before I buy their stock, I might as well learn from the best in the business.

The book breaks it down into 4 parts. The balance sheet, income statement, cash flow statement and shareholders equity/book value.

Here is the Income statment & balance sheet part which I have summarized. Look out for the other sections soon to come. For more info like this feel free to visit my blog (check the sig below)

Income Statement

1) Gross profit margin = Gross Profit/Total Revenue
a. Firms should have consistently higher gross margin profits 40% and above.
b. Gross profit margin of 20% and below shows high competition
c. Track the gross profit margin for 10 years to see consistency

)2) Selling, administrative and General costs-
a. The lower the better. Look for a range of 30-80% of gross profit

3)Research & Development –
a. firms that have to spend a lot on R&D have an inherent flaw in their competitive advantage which puts their long term economics at risk and should be avoided.

Read The Rest Of The Entry Here

Balance Sheet

1) Cash & Marketable securities-
a. If we see a lot of cash and marketable securities and little or not debt, then the firm will sail through troubled times. If the firm has little cash and a mountain of debt, then it is considered a sinking ship.

b. Look at the past years to see if the cash has been coming in steady or in one shot from the sale of bonds and shares. If we see a ton of cash piling up, with little or no debt, and no sales of new shares or assets, and we note a consistency of earnings, then it is an excellent business with a durable competitive advantage.

2)Inventory-
a.Look for inventory and net earnings that are on a corresponding rise. This indicates that the firm is finding profitable ways to increase sales.

3)Net Receivables
a.If a firm is consistently showing a lower percentage of net receivables to gross sales than its competitors, it usually has some kind of competitive advantage.

4)Property Plant & equipment –not having them can be a good thing
a.Firms that constantly have to update manufacturing facilities to try and stay competitive before equipment is worn out are not durable which keeps adding the amount of plant and equipment the firm has on its balance sheet

b.A firm that has a durable competitive advantage doesn’t need to always upgrade their equipment to stay competitive, also they will be able to finance new equipment internally without having to finance it using debt.

5)Goodwill-
a.If there is a constant increase in goodwill, then a firm has been acquiring different companies which ultimately can give them a durable advantage.

b.If the goodwill account stays the same year after year it is because the firm is either paying under book value for a firm or the company is not making any acquisitions.

6)Long term investments

a.This figure is carried on the books at cost price. So even if their investments have grown considerably, it will only show up on the balance sheet for what they bought it for.

b.This figure can also tell a lot about the firm’s management in terms of if they invest in durable firms or lousy firms.

7)Total assets and ROA
a.Important in determining how efficient the firm is putting its assets to use

b.ROA is found by dividing net earnings by total assets

c.Really high ROA may represent vulnerability in the durability of a firm’s competitive advantage.

d.Sometimes more can actually mean less over the long term.

8)Short Term Debt

a.Less is more; Wells Fargo has 57 cents of short term debt for every dollar of long term debt.

b.Although financial institutions in general borrow a lot of money, look for those that lend long term and borrow long term.

9)Long term debt
a.As a rule, companies with a durable competitive advantage require little or no long term debt to maintain their business operations and therefore have little or no long term debt ever coming due.

b.Dividing the total current assets by total current liabilities one can determine the liquidity of the company, the higher the current ratio the more liquid the company

c.Most durable firms have a current ratio less than one. This goes against the traditional way of thinking as having a ratio of 1 or higher is desired. This anomaly renders the current ratio as being void in identifying a firm with a durable competitive advantage.

d.Any time we are buying into a firm that has a durable competitive advantage, but has been going through troubled times due to a one time solvable event it is best to check the horizon and see how much the firms long term debt is due in the years ahead. Too much debt coming due in a single year can spook investors, which will give us a lower price to buy in at.

e.Look at the long term debt that the company has been carrying for the last 10 years, if there has been 10 years of operations with little or no long term debt, then it has a durable competitive advantage.

f.On any given year the firm should have sufficient yearly net earnings to pay off all of its long term debt within a 3 to 4 year earnings period. Little or no long term debt often means a good long term bet.

10)Total Liabilities and the debt to shareholder equity ratio
a.Debt to shareholders equity ratio= Total liabilities/shareholders equity

b.In order to get the real picture, convert the negative value of the treasury
shares to positive and add it to the shareholders equity, then the debt to equity ratio should drop.

c.Simple rule here is that unless we are looking at a financial institution any time we see an adjusted debt to shareholders equity ratio below .80 (lower the better) then the company has a durable competitive advantage.