Analyze A Common Size Balance Sheet, Income Statement and Other Financial Statements – Common Size Analysis
What is the Difference Between a Common Size Balance Sheet and a Regular Balance Sheet?
Common Size Analysis of Financial Statements involves looking at the numbers on the financial statement as a percentage of a total rather than their absolute value. Typically investors will look at a company’s common size balance sheet and common size income statement.
This is helpful when not only looking at a single company’s financial statements, but also comparing multiple business of different sizes at one time. Let’s take a look at an example of a normal balance sheet and a common size balance sheet for several companies:
At the time Warren’s investing style, taught by Ben Graham, was to look for “cigar butt” stocks – stocks that were dirt cheap, but provided a “free puff” to investors willing to make the investment. Berkshire certainly could have filled that criteria, here is how Buffett tells the tale:
9 Examples of a Competitive Advantage (#9 is One of Buffett’s Favorite Type to Look For!)
Finding a company with a competitive advantage means finding an investment that will offer solid returns for decades to come. What identifies a company with a strong competitive advantage? Some results may surprise you.
“…managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.”
There is so much more to finding a good investment than finding a specific ratio on a company’s balance sheet. As Buffett says, evaluating a company’s financial statement should be the beginning of your research, not the end.
Buffett has made his billions by identifying companies with strong competitive advantages, and buying and holding those companies for decades (Or as he says, preferably forever).
A strong competitive advantage means that a company will continue to make profits year in and year out, no matter the economic or political environment. It maximizes shareholder wealth by harnessing the power of compounding interest in its accumulated earnings.
But, a strong competitive advantage is not identified just by looking for a certain Price to Book (P/B) or Price to Earnings (P/E) ratio. Instead, it means understanding how the business operates and how the company’s financial statements identify advantages the company has its in field.
For example, consider Coca-Cola’s current ratio. Historically, it has been under 1. Any basic stock screen that excludes companies with current ratios of less than 1 (which is a quick test to see which companies can afford to pay their bills over the next 12 months, read more on current ratio here), would have excluded Coca-Cola from the results.
How can it be possible that one of America’s strongest companies looks like it won’t be able to afford to pay its bills by a simple ratio like the current ratio? It turns out, this may in fact be a sign of a significant competitive advantage for a select set of companies!
A low current ratio is #4 below, here are the rest:
Breaking Down a Company’s Asset Growth With Analysis of the Changes in its Balance Sheet
Generally, increasing assets are a sign that the company is growing, but everyone can relate to the fact that there is much more behind the scenes than just looking at the assets. The goal is to determine how the asset growth of a company is financed.
To do so all we need is the last few years of a company’s balance sheet and the most basic financial statement equation:
The assets of a company are what the company owns. Typical examples of assets are; equipment to make a product, buildings owned, raw materials to create a product, inventory of the product to sell and cash in the bank.
Think of your household. Your car, your home, your furniture, TVs, Computers, bank accounts etc.
Generally, increasing assets are a sign that the company is growing, but everyone can relate to the fact that there is much more behind the scenes than just looking at the assets. Back to our household example:
Imagine watching a neighbor pull a sparkling brand new BMW into their driveway, getting out dressed in his fancy Italian suit, talking on the latest smartphone, and coming over to ask if you can watch his house for 2 weeks while he travels to sail in the Caribbean. You may think he is making it big, right? Maybe he got a big bonus from work, or a promotion…
That may very well be the case, or he may be racking up debt (liabilities) to finance these assets.
You may never find out which option applies to your neighbor, but thankfully the SEC requires publicly traded companies to be a little more transparent with their financials than your neighbors. [continue reading…]
The first step in finding potential investment opportunities is to be able to go through and evaluate a company’s financial reports. In this article we evaluate the Cash Flow Statement, one of the most useful of the three financial statements.
How Much is TOO Much to Pay for a Wonderful Company? A Look at a Current Great Business, and Buffett’s Past Purchases
One of the more famous investment quotes, which represents a mindset that has created one of America’s most valuable companies, from one of the most successful investors of all time:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett
And that got me thinking…At what price did Buffett purchase some of his “wonderful” businesses and how does that compare to some “wonderful” stocks today? And what is considered a “fair” price? [continue reading…]
Evaluating Financial Statements – Statement of Shareholder Equity
We have previously discussed the more well known financial statements; the balance sheet, income statement and statement of cash flows, but there is one additional financial statement you will see listed within every company’s 10-k report, the statement of shareholder equity. Value investors like Warren Buffett consider information within this report as some of the most important and telling signs of a company’s health. Here is why:
So really, shareholder equity should be considered the net worth of the company, or what the company is worth if all its assets were sold and debts settled.
The Statement of Shareholder Equity depicts the value of the company and describes where that value comes from and how it has changed over time for investors. [continue reading…]
Evaluating Stocks with a Competitive Advantage – Warren Buffett’s Concept of an “Equity/Bond”
When a company’s earnings are so solid and so predictable, investors are able to think of their stock like a variable fixed income security, like a bond with flexible rates. Here is how investors like Buffett evaluate these special companies. [continue reading…]
10 Questions to Ask Before You Buy Your Next Stock
How do you determine whether a stock is a worthy long term investment? Here are a few questions to ask yourself before you make that next purchase. [continue reading…]
Investing Book Series: “Competitive Strategy” Chapter 1 and Using it to Find Your Next Great Investment
Evaluating Financial Statements – The Income Report
The first step in finding potential investment opportunities is to be able to go through and evaluate a company’s financial report. In this article we evaluate the Income Report and show how investors can use the information within the income report to uncover potential value.