Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage

by Mary Buffett

All publicly traded companies must file quarterly financial statements with the SEC; these are known as 8Qs. Also filed with the SEC is a document called the 10K, which is the company’s annual report.

The equation for determining gross profit margin is: Gross Profit ÷ Total Revenues = Gross Profit Margin

The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include: Coca-Cola, which shows a consistent gross profit margin of 60% or better; the bond rating company Moody’s, 73%; the Burlington Northern Santa Fe Railway, 61%; and the very chewable Wrigley Co., 51%.

Ideal gross profit margins to have

poor long-term economics, such as the in-and-out-of-bankruptcy United Airlines, which shows a gross profit margin of 14%; troubled auto maker General Motors, which comes in at a weak 21%; the once troubled, but now profitable U.S. Steel, at a not-so-strong 17%; and Goodyear Tire—which runs in any weather, but in a bad economy

Poor profit margins

As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too).

Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition.

Warren strongly emphasizes the word “durable,” and to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the “consistency” is there.

In the world of business anything under 30% is considered fantastic.

What we want our SGA expense percentage to be

Here then is Warren’s rule: Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.

What Warren has discovered is that companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition. As an example, Coca-Cola’s depreciation expense consistently runs about 6% of its gross profits, and Wrigley’s, another durable competitive advantage holder, also runs around 7%.

As a rule, Warren’s favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.

The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.

What he has learned is that companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long-term competitive advantage. Likewise, if a company is consistently showing net earnings under 10% on total revenues it is—more likely than not—in a highly competitive business in which no one company holds a durable competitive advantage.

To determine the company’s per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding.

This shows Warren that the company has consistent earnings with a long-term upward trend—an excellent sign that the company in question has some kind of long-term competitive advantage working in its favor.

So here is the rule: If we see a lot of cash and marketable securities and little or no debt, chances are very good that the business will sail on through the troubled times. But if the company is hurting for cash and is sitting on a mountain of debt, it probably is a sinking ship that not even the most skilled manager can save.

If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favor that the others don’t have.

current ratio, which is derived by dividing current assets by current liabilities; the higher the ratio is, the more liquid the company. A current ratio of over one is considered good, and anything below one bad.