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How to invest like Warren Buffett | Part 3 | Balance Sheet

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In this 3rd Post of the series “how to invest like Warren Buffett” we explore the Balance Sheet and how to analyze stocks and apply the principles of value investing through this financial statement.

Investing like Warren Buffett or like a value investor means being able to find promising companies which are selling at a low price compared to their intrinsic value. The only way to properly invest for the long term is by being able to understand how to read and interpret financial statements and I know, it sounds hard at the beginning but in these videos we are going to easily go through all the important parts of these statements so that whenever you want to invest in a company you are going to be able to check all its financial data and make a rational decision. In this particular video we are going to talk about the second most important financial statement, which is the balance sheet. Are you ready? Let’s start.

Introduction

What’s up people, this is Rick and in this video we are going to talk about the interpretation of Balance Sheets as a value investor. If you haven’t seen part 1 and 2 of this series of videos, go take a look at them first – I will link them on the description below and here on the screen I’ll link the number 1. The first 2 videos were about the durable competitive advantage and about the income statement, while now we’ll deep dive into the balance sheet and all its important components.

So, assuming that you’ve watched the first 2 videos and know everything about the DCA and the income statement, Let’s focus now on the balance sheet and to do that, just like we did in the other video we’ll take the statement from the Coca Cola Company as an example.

Balance Sheet

Just as we did for the Income Statement in the last video, from the 10k of Coca Cola let’s click this time on consolidated balance sheets and we’ll see we get to a table which is divided into Assets, Liabilities and Equity. 

Now, balance Sheets, unlike Income Statements, are only for a set date, not for a period of time. When we analyzed the income statement in the last video, we saw that the income statement draws a picture of a whole period, like a quarter or a year. The balance sheet works differently and is like a photo of an instant of the company, and draws a picture of the assets, the liabilities and the equity of that company in that particular instant, which is usually the end of the fiscal quarter. Now, to give you an example: you can create a statement where you write everything that you’ve earned in a year from your job, and everything that you’ve spent for food, games, clothes and whatnot. That would be your income statement. But then at the end of the year you look at your pocket and you look at everything you possess, like your money, your car, the stuff in your room, your debts and so on, and this list of everything you have and owe on that precise moment would be your balance sheet.

So as we said,  the balance sheet is divided into “Assets, Liabilities and Equity”. Assets are the items you own that can provide future economic benefit. Liabilities are what you owe other parties. In short, assets put money in your pocket, and liabilities take money out!

Assets are basically cash and properties a company possesses. Liabilities are for example the money they owe to banks to get financed and you can’t imagine how much every company owes to banks. The so-called Leverage, which is borrowed money, is one of the main reasons a company fails.

Now, if you imagine that you have a certain value of Assets, which are a good thing, and a certain amount of Liabilities, which is not a good thing, the difference between the 2 is the so-called Equity, or Shareholders’ equity. If you have a good company and your assets are more than your liabilities, then you have a positive equity. If you are a bad company and have more liabilities than assets, then you’d have a negative equity.

Here as example the Balance Sheet 2021 from the Coca Cola’s 10k:

Let’s go now through the assets first.

Assets

Assets are divided into Current Assets and All Other Assets

Current Assets is made up of everything that is cash or can be converted to cash within a year. Some typical items of assets are Cash and Equivalents, Short Term investments, Accounts receivables and Inventory.

Other Assets (or long Term Assets) are everything that cannot be converted into cash within a year, like Long Term Investments, Property, Plant & Equipment, Goodwill and so on.

Cash and Equivalents

So, first item: Cash and equivalents. This is exactly what it says it is: Cash or equivalents such as three month treasures from the bank or other liquid assets.

High Cash can mean 2 things:

  • The company has a DCA and makes a lot of money, which is good
  • The company has just sold a business or tons of bonds, which is not good

A low amount of Cash, on the other hand, is basically always bad.

Traditionally, companies have been using excess Cash to expand operations, invest in other businesses, buy back their shares or pay out Cash Dividends to the Shareholders. Quite often, though, they stack it for a rainy day.

If the company has a lot of Cash in the balance sheet and low Debt or liabilities, chances are that the company will survive future problems or crisis.

To understand what is generating the Cash for the company you can look at the last 10 years of the Balance sheet, for example through QuickFS.net. You will see if the Cash has been generated in one time or whether it was generated every year by the business operations. As I already said: always look for consistency! And if you see a lot of Cash, no sales of assets and little or no debt, you probably found an excellent company with a DCA. 

Accounts Receivable / Net Receivables

Now after Cash let’s see what Accounts receivable are. Accounts receivable is money owed to the company. When you buy something on Amazon and Amazon allows you to pay 30 days later, during that period of time Amazon still doesn’t have the cash from you, therefore that amount is stored as Receivables.

Net Receivables as a standalone position tells us little about the company, however it tells us a great deal if we compare different companies of the same industry.

If the gross sales increase more than the receivables, it usually shows some kind of competitive advantage.

Inventory

After that you find inventory. Inventory is the company’s product which is warehoused and ready to be sold.

When you try to identify a Manufacturing Company with a DCA look for Inventory (Balance Sheet) and Net Earnings (Income Statement) and check if they are on a corresponding rise. This indicates that the company has found a profitable way to increase Sales and that increase of Sales has called for an increase in Inventory.

If the inventory ramps up on some periods and drops down in others, this is most probably not good because it means that the company works in a competitive industry.

Prepaid Expenses / Other Current Assets

Prepaid Expenses give us little information about DCA or about the company in general, but just to clarify the meaning, Businesses sometimes pay for goods or services that they will receive in the near future. You can see Prepaid Expenses as the opposite of Accounts Receivable, since in this case it’s the company in question which paid and waits for the good or service.

Total Current Assets and Current Ratio

Now, Total Current Assets play an important role in financial analysis and the comparison between the current assets and the current liabilities of a company is an important information to understand whether the company can meet its short term debt obligations. Imagine if a company has a lot of liabilities and not enough assets, if they need to pay back the money from the liabilities or in case of crisis they are not going to be able to pay their debts back, and this can lead to bankruptcy. Therefore analysts developed the Current Ratio, which is calculated by dividing Current Assets by Current Liabilities.

A current Ratio of >1 is considered good. Under 1, the company may have a hard time meeting its short term obligations to its creditors.

But it’s important to notice: Many times, companies with a DCA have a current ratio which is below the magical 1. What happens here is that these companies earn so much that they can easily cover their current liabilities, Because of their strong earning power they can also pay out generous dividends and make stock repurchases, both of which reduce the assets and help bring the Current Ratio below 1.

Long Term Investments and other non current assets

Now, after the current assets, we have all other long term assets. One of them are “other investments”, which are long term investments such as Stocks, Bonds and Real Estate.

Then we have other non current assets, which are Assets with a life of longer than a year that didn’t make it into the particular categories that you see here like “Property, Plant and Equipment”, “Trademarks”, “Goodwill”, and so on. This position doesn’t tell us much.

Property, Plant and Equipment

Now let’s see Property, Plant and Equipment. For Buffett, not having them can be a good thing. Companies that don’t have any DCA are usually faced with constant competition, which means they constantly have to update their plants and manufacturing facilities to stay competitive. Companies with a DCA don’t have to update their equipment and plants except if they wear out. Buffett often makes the example of Coca Cola or a Chewing Gum Company like Wrigley, which I don’t necessarily suggest to invest in but are example that Buffett gives to explain that if a company has a winning product they don’t need to constantly change it and they can keep selling it for decades without having enormous expenses in plant and equipment. 

Goodwill

Now, after that we have Trademark, which you already know, and then Goodwill. Goodwill is an intangible asset that is created when the company acquires another company for a price greater than its net asset value. So if Goodwill increases over the years and you know that the company is buying other good companies, then it’s a good thing.

If goodwill stays the same, it means that the company when acquiring other companies is either paying less than book value or is not acquiring. Buying a company for less than its book value may not be a good thing because it can mean that they are buying a company in a financial crisis or without a DCA.

Intangible Assets

Then we have Other Intangible Assets. They are patents, copyrights, other trademarks, franchises, brand names and the likes. We don’t need to spend so much time on this but there is a particular aspect to consider: If a company develops a brand internally, like “Coca Cola” that wasn’t bought but was created by the company itself, then these brands are not reflected on the balance sheet. And this is one of the reasons competitive advantage power can remain hidden for so long.

Total Assets and the Return on Total Assets

So, add current assets to all long-term assets and you get the company’s total assets.

Now, there is an important Ratio that I’d like to introduce to you. It’s the so-called Return on Asset Ratio (ROA) that determines how efficiently the company puts its Assets into use and is calculated as: Return on Asset Ratio = Net earnings / Total Assets

The net earnings come from the income statement and the total assets from the balance sheet. Now, while having a high ROA is important, if a company has an excessively high ROA it may indicate vulnerability in the competitive advantage. This is because the value of a company is calculated also through its assets, and if a company has a lot of earnings but doesn’t acquire many assets, it’s going to be easy to take it over. 

Liabilities

So, we talked enough about assets, let’s focus now on liabilities.

Just as for assets, there are two types of liabilities: Current and Long Term:

  • Current Liabilities: The money that is owed within a year, like cash and short term investments, total inventory, total receivables and prepaid expenses
  • Long Term Liabilities: include money owed to the vendors that sold goods to the company, unpaid taxes, bank loans and similar. 

If we subtract the liabilities from the assets we will get the net worth of the business, which is the Shareholders’ Equity:          Assets – Liabilities = Net Worth (or Shareholders’ Equity)

Current Liabilities

Let’s start from the current liabilities. They are the debts and obligations of the company that are coming due within the fiscal year.

Accounts Payable and Accrued Expenses

The first we see here in the coca cola 10k are Accounts payable. Accounts payable is money owed to the suppliers that have provided goods and services to the company on credit. The supplier sends the goods or services together with an Invoice, and the company still needs to pay this bill.

Accrued Expenses are liabilities that the company has incurred but has yet to be invoiced for. For example the company hires someone and agrees to pay him at the end of the month. Each day of that month is booked as an accrued expense.

All these short term titles as stand-alone terms tell us nothing about the DCA and the long-term stability of the business. For this we also need long term items.

Short Term Debt

Now in many cases or if you check the statement from a website you are going to find an item called Short Term Debt. In this Coca Cola 10k the Short Term Debt is divided in 2 voices, Loans and notes payable and Current maturities of long-term debt. In general, Short term debt is money lended to the company and due within a year. When it comes to investing in financial institutions, Buffett always stays away from companies that are bigger borrowers of short term money than of long term money, because short term debts are more dangerous and sometimes the financial institution is not able to pay back the short term debt anymore. 

So if you intend to invest in financial institutions, always look for a small portion of short term debt compared to long term debt.

The second item, which as I said is also a short term debt, is called Current maturities of long-term debt and is basically Long-Term Debt coming due within the fiscal year. As a rule, companies with a DCA require low or no long-term debt to maintain their business operations, and therefore have low or no long-term debt coming due.

So these are all the current liabilities, and as we already discussed before if you divide

Total Current Assets by Total Current Liabilities  you get the Current Ratio, which tells you whether the company can meet its short term debt obligations.

Long-term Debt

Let’s move on now to the long term liabilities and we start with probably the most important term: the Long-Term Debt. Companies with a DCA often carry little or no long-term debt. This is because they are so profitable that they are self-financing when they need to expand their business or make acquisitions. Always look at at least 10 years of operation with consistent low long-term debt. Moreover, the company should consistently have enough net earnings to pay off all of its long-term debt within a three to four year earnings period. So let me show you how you can calculate this. You check the Net Earnings from the income statement and the Long-term Debt shouldn’t be more than 3 to 4 times bigger than that. This means that if needed the company can pay off their long term debt in less than 4 years of Net Earnings. The rule here is simple: Always look for Little or no Long-term debt.

Finally there are other liabilities, but we are not going into detail on these because they tell us little about DCA.

Total liabilities and the debt to shareholders’ equity ratio

So, summing up current and non current liabilities you get the total Liabilities. Another important ratio that is used a lot is the “debt to shareholders’ equity ratio”, which is the ratio between total liabilities and equity. Historically it has been used to help identify whether or not a company is using debt to finance its operations or equity. Companies with a DCA should in theory show a higher level of shareholders’ equity and a lower level of total liability. The only problem is that great companies with a lot of earnings don’t need much equity to get the job done, and often spend their retained earnings on buying back their stock which decreases their equity. When a company buys back their own stock they build the so-called Treasury Stock. So if the equity decreases, the debt to equity ratio increases and makes them look like they have a lot of debt. In order to avoid falling into this trap, you can calculate the ratio adding to the shareholders’ equity also all the treasury stock acquired through stock buyback. This is called Treasury stock adjusted debt to shareholders’s equity and is calculated as: Total Liabilities / (Shareholder’s equity + Treasury shares)

Shareholders’ equity or book value 

When you subtract all liabilities from all assets you get the net worth of the company or Shareholders’ equity which is also called Book Value of the business. Total Liabilities + Equity must equal Total Assets, that’s why it’s called a “Balance Sheet”. 

There is an important ration which is the Return on Equity, ROE. It’s calculated as 

Return on Equity: Net Earnings (After Tax Income) / Shareholders’ Equity

The return on shareholders’ equity ratio shows the management’s efficiency in allocating the shareholder’s money, or in other terms it shows how much money is returned to the owners as a percentage of the money they have invested or retained in the company. A high Return on Equity means the company is making good use of the money they are retaining.

Companies with a DCA have a higher than average Return on Equity compared to their industry. Good companies often have a return on Equity of around 30%. Companies in highly competitive markets like airlines, where no one has a DCA, have Return on equity of around 0 to 10%. One important note: Some companies like good tech companies constantly earn so good that they don’t need to retain any money and invest all of it. In this case, they might even show negative Shareholders’ Equity in some years. But also insolvent or weak companies show low or negative Shareholders’ Equity. To avoid mistakes, you should always check if a company has a history of strong net earnings when you see a negative Return on Equity.

Now, this shareholders’ equity consists of different elements, for example Preferred and Common Stock, Capital surplus and so on. We are not going to discuss every term here but we’ll focus now on Retained or reinvested Earnings and Treasury Stock.

Retained Earnings

When a company has earnings they can do 3 things with them: pay them out to shareholders as dividends, reinvest them into the expansion of the business or buy back their stock. Reinvested earnings or retained earnings are the part of the profit that’s reinvested in the business.

Retained earnings is one of the most important numbers to understand if a company has a DCA. If the Retained earnings don’t grow, the net worth is not growing, so always look for growing retained earnings.

Treasury Stock

So, as we said, other than paying dividends or reinvesting the earnings, the company can also buy back its own shares. And this is found in the so-called Treasury Stock item. Now, the presence of Treasury Shares on the balance sheet is important to find a company with a DCA. Treasury stocks, although they are an asset, are carried with a negative value, therefore they decrease the Shareholders’ equity, and this in turn automatically increases the Return on Shareholders’ Equity, which was Net income / Shareholders’ equity. Since the Return on Shareholders’ equity is so important to determine a possible DCA, it’s important to understand if the ratio is high because the net income is high or because of treasury stock that decreases the shareholders’ equity.

So, in order to obtain a comparable value of Return on Equity, there is a way where you basically adjust it using the Treasury stock:

Add Treasury stock to the Shareholders’ Equity, and use this as denominator to the Net Income instead of the only Shareholders’ Equity:

Adjusted Return on Equity: Net Earnings / (Shareholders’ Equity + Treasury Stock)

The problem with leverage

To give you a last important tip, try to always avoid businesses that use a lot of leverage to generate their earnings. Leverage is the use of debt to increase the earnings of the company. This is a major point when investing into financial institutions, but in general, when you want to invest in whatever company, try to avoid companies that have high levels of debt. 

Conclusions:

So, to summarize in general you need to look for companies that have more assets than liabilities and that have little or no debt. There are many small nuances to this and I tried to describe as many points as possible in a single video without hopefully overwhelming you.

In order to make it easy, I also prepared a 2-pages summary of today’s points that you need to consider when analyzing the Balance sheet of a company and you can download it for free from the link in the description below. Of course, if you found any use in this video be sure to subscribe to my channel to show me some support and be notified of my next video, which is going to be about the last financial statement: the Cash Flow Statement. So don’t miss it, I’ll see you in the next video. Ciao!

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