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No. of Recommendations: 20
Title was too long for the subject box, but here is the complete book name and authors: Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark

Since Neil has now recommended this book twice, I thought I would crosspost this here. I originally posted this a couple of months ago on the Stock Advisor Book Club Board.


A few weeks ago, I announced my complete inability to read or make any type of sense of company balance sheets on a few boards. Thankfully, the wiser members of the Foolish community took pity on me and pointed me in the right direction. But while I originally thought I was going to be able to get away with skimming over a few articles touching on the subject and then return my attention to matters more fitting, like LOL Cat posts on Buzzfeed, I soon realized that this was going to take quite a bit more studying. That, gulp, it might even involve reading a book or two on the subject.

A few weeks ago I vowed to get better at reading company financial statements. Several books were recommended to me but I started with Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark. While I wasn’t sure where to start in my reading, I believe choosing this book first was a fortuitous choice for several reasons: 1) It was fairly short and easy to read; 2) It’s fairly basic and carefully walks you through each line item on a sample balance sheet; and 3) As the authors walk through each line item, they discuss what some guy named Warren Buffett looks for on balance sheets when he makes an investment.

The book is roughly divided into three sections, each walking us through the “three distinct flavors” of financial statements:

1) The Income Statement –
The authors write, “The income statement tells us how much money the company earned during a set period of time…Using a company’s income statement, Warren can determine such things as the company’s margins, it’s return equity, and, most important, the consistency and direction of its earnings.”

2) The Balance Sheet: The authors explain, “The balance sheet tells us how much money the company has in the bank and how much money it owes. Subtract the money owed from the money in the bank and we get the net worth of the company…”

3) The Cash Flow Statement: This statement “tracks the cash that flows in and out of the business” and shows potential investors how much is being spent on capital improvements, bond sales and stock repurchases, among a great deal of other things.

Each section is broken into a number of fairly short chapters, usually between only two to four pages each, breaking down the line items found on each of these statements. I really like this format because I found that even if I only had five minutes, it was still ample enough time to sit down and read a quick chapter. The format should also make it easy to use as a reference guide going forward. If I’m ever confused by a line item on a balance sheet of a company I’m studying I don’t have to go digging deep into a chapter, I can just turn to the chapter written specifically for that figure.

As an example of this type of breakdown, in the balance sheet section, this is from the chapter on Cash and Cash Equivalents:

One of the first things Warren does is to look at the assets to see how much cash and cash equivalents a company has. This asset is exactly what it says it is— cash— or it is the equivalent of cash, such as a short-term CD at the bank, three-month Treasuries, or other highly liquid assets. A high number for cash or cash equivalents tells Warren one of two things— that a company has a competitive advantage that is generating tons of cash, which is a good thing, or that it has just sold a business or a ton of bonds, which may not be a good thing. A low amount or the lack of a stockpile of cash usually means that the company has poor or mediocre economics. To figure out which is which, let’s look a little deeper at the asset of cash...

Each chapter is like this: Taking a line item from the financial statement, defining it, and then explaining what, if anything, Buffett likes or dislikes when he looks at this line of a financial statement.

One of the overarching themes of the book and, apparently Buffett’s investing style, is the search for companies with a “durable competitive advantage”. For instance, in the chapter on Capital Expenditures in the cash flow statement section, the authors write:

When it comes to making capital expenditures, not all companies are created equal. Many companies must make huge capital expenditures just to stay in business. I f capital expenditures remain high over a number of years, they can start to have a deep impact on earnings. Warren has said that this is the reason he never invested in telephone companies – the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.

As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.

It’s good stuff and has made me think about investments in ways I haven’t really done before. I honestly thought Buffett never invested in technology stocks because he didn’t really “get it” and thus just decided to stay away. But one of the disadvantages of being in the technology sector is that you must continually innovate or risk having your products and/or services becoming obsolete before too long. This requires constant investing in research and development or expensive factory renovations/additions which can really start to place a drag on earnings. I never thought about this aspect before and will have to give it more thought.

All in all, this was a great little book that I believe will come in very handy in the years ahead as I try to evaluate companies on a deeper and deeper level by looking over their financial statements. If you’re like me, a financial statement illiterate, this is a good place to start learning. It’s easy to read and explains everything on a step-by-step basis. As an added bonus it explains what one of the world’s greatest investors ever looks for in company financial statements. I definitely recommend it!

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