7
Accounting Fundamentals: The Report Card for Businesses

“Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress.”

—Warren Buffett, 1986 Letter to Berkshire Hathaway Shareholders

Introduction

Students get a report card. It's a measure of how you performed in your classes over the course of the marking period. In business, companies have their own type of report card. They're called financial statements, a term we introduced in Chapter 1. Understanding the “report card” of a business is an important part of financial literacy. It provides you with insights related to how companies act and how they've performed. And who knows? Maybe you'll have your own business someday, and then you'll have to understand this stuff in even greater detail, since it's what you'll have to show to your investors.

It's worth your time to grasp the basics of accounting and financial statements now. In fact, when one teen asked Buffett for financial advice, Buffett suggested, “Take all the accounting courses you can.” In his 1986 Letter to Berkshire Shareholders, Buffett called accounting the “language of business” and said he and his business partner, Charlie Munger, use it as the basis for evaluating businesses. Here's the full quote.

“Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: They invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.” Let's summarize these points with a Tip.

There are two types of companies, for profit and nonprofit. Nonprofit institutions include governments, charities, and most schools and religious organizations. Their goals are often not related to making money. For example, schools mainly exist to educate their students. However, nonprofit doesn't necessarily mean no profit. If these nonprofits do generate profits, they are reinvested in the institution.

We're going to discuss charity later in the book since it's a big part of Buffett's character and the ultimate destination for his money, but for now, we're going to focus on firms that try to make money. These are for-profit firms, such as Apple, Facebook, Disney, and—of course—Berkshire Hathaway. Both types of groups have financial statements, but we'll get a better feel for them when talking about profit-seeking firms.

Businesses sell something—usually a product or a service. Let's start with a firm selling a product since it's a bit easier to visualize. Warren Buffett's first business was buying packs of gum from the supermarket (through his grandfather) and selling them to his friends and neighbors at a higher price. As mentioned in Chapter 1, the difference between the price at which something is sold and all the costs involved in selling it is usually called either profit or earnings. If the number is negative, that is, the firm sells a product at a price less than what it costs to make it, it's called a loss. The notion of profit and loss and the current financial condition of a firm are what financial statements are mostly about.

The Income Statement: A Company's Report Card for One Period

Most companies produce financial statements on a quarterly basis, typically at the end of March, June, September, and December. These quarterly statements, or quarterly reports, roll up into an annual statement, or annual report. The reports include other things besides financial statements. For example, we have often referred to the letters Buffett writes to Berkshire Hathaway's shareholders. But we'll put those non-financial things aside for now. The watchdog of the US financial markets, known as the Securities and Exchange Commission (SEC), requires companies trading on stock exchanges to file these reports. The SEC calls the quarterly report a 10-Q and the Annual Report a 10-K.

Most company's annual reports cover the period January 1 to December 31, the calendar year, but there are some exceptions. The year used when computing financial statements is called the fiscal year. For most firms, the calendar year equals the fiscal year. But here's a common exception: colleges. Colleges usually have a fiscal year that goes from July 1 to June 30, to align it with the academic year.

The financial statements are produced by the people running the firm, its management, but they are audited by accountants. Audited means to check out, or to try to verify that the numbers are accurate and prepared according to the rules. The rules for companies that trade on a US stock exchange are called Generally Accepted Accounting Principles (GAAP). Many international firms follow a slightly different set of rules, called International Financial Reporting Standards (IFRS). Technically, only a special type of accountant is able to conduct an audit. These “black belt” accountants are called Certified Public Accountants, or CPAs for short. They have to pass a range of exams and must have taken a certain amount of accounting and college courses in order to call themselves CPAs.

There are thousands of accounting firms, but four huge ones do most of the audits for big, publicly traded companies. Not surprisingly, in business they are known as the “Big Four.” In case you wind up on Jeopardy, we'll tell you their names: Deloitte, Ernst & Young (E&Y), KPMG, and PricewaterhouseCoopers (PwC).

Apple's Income Statement

The first financial statement that we're going to tackle is called the income statement. It measures the profit or loss for a firm over a specified period of time. Sometimes it's called the profit and loss statement, or P&L for short. You can think of the income statement as the report card of a firm for one period, typically a quarter or a full year. Let's look at a simplified income statement for Apple, one of the most valuable, profitable, and coolest firms in the world. It's simplified since we don't want you to need a degree in accounting to read this book. We'll examine its income statement for the 2019 fiscal year, shown in Figure 7.1.

We'll start with the top line number known as revenue. Revenue also goes by other names, such as sales or net sales, if you make adjustments for things such as returns, discounts, and other allowances. We're sure you've stood in a line at some point in your life to return a gift you didn't want from the holiday season, such as the proverbial ugly sweater or fruitcake. If so, your actions have been included in the net sales of some firm even if you didn't realize it.

In Apple's case its revenue comes from the sale of its products and services. It comes mostly from the sales of its hugely popular iPhone but also from its other products and services such as Macs, iTunes songs, iPads, apps, Beats headphones, and many other things. Apple had immense revenue of $267.68 billion in fiscal year 2019. That's bigger than the sales generated by some entire countries!

Figure 7.1

Apple Income Statement (Simplified)
Fiscal Year 2019 ($ billions)
Revenue $267.68
Less: cost of goods sold (COGS)
Gross profit
images
Less: selling, general & administrative
Operating income
images
Plus: other
Less: income taxes (15.08%)
1.60
10.22
Net Income $57.53

Well, it costs something to run a business. We're going to look at the two main cost items. The first is the cost of producing the item, such as the iPhone. Accountants call that term by the formal name of cost of goods sold. Cost of goods sold often goes by the acronym COGS. Apple had COGS of $166.10 billion in fiscal year 2019. Accountants know when to add or subtract something on a financial statement, but we're going to try to make it easy for you. If we put the word “Less” next to an item, that means you subtract it from the number above. We'll also occasionally put an underline symbol too, known in accounting speak as single accounting underline. So in our mini Apple income statement you'll see “Less: cost of goods sold.” The difference between net revenue and cost of goods sold is called gross profit.

Sticking with our iPhone example, Apple might charge $1,000 for a phone that costs them $500 to make, resulting in a gross profit of $500 per phone. Is that a good number? It is, but to answer it more precisely you should compare Apple's numbers to its competitors', such as Samsung and Alphabet (the parent company of Google). You should also compare the current values of Apple for any statistic to its values in prior years. If the gross profit is increasing per phone sold, it tells you the company is getting stronger and building up its moat, in Buffett speak. A lean, mean fighting machine!

Analysts sometimes use another technique to determine if a specific number is good or bad. They often divide a specific item, such as gross profit, by sales. These financial ratios (dividing one financial variable by another) make it easy to make comparisons across firms, and across time for the same firm, since everything is expressed by a percentage. Thus, in this instance, if Apple had a higher gross profit-to-sales ratio, known as a gross margin ratio, than Samsung, it would be considered to have done better in this aspect of its financial report card. The term “common-sizing” a financial statement refers to dividing items on the income statement by sales (i.e., creating ratios that express things as a percentage of sales) and dividing items on the balance sheet (covered in the next section) by total assets.

But Apple has other costs too, such as wages. You wouldn't work full-time for a company for free, would you? At least not for too long. Apple also has to pay other expenses, such as the cost to set up shop in the mall, typically called rent or a lease obligation. Apple also has to put money aside to invent new products. That iPhone, iPad, or Apple Watch that you love was once just a glimmer in someone's eye more than a decade ago. Funds put aside to invent new products and services go toward research and development, or R&D for short. We'll put all of these costs into a term informally known as overhead. The formal name that accountants use for overhead is selling, general, and administrative, or SG&A for short. This is the second main cost of running a business that we alluded to earlier.

Apple had SG&A expense of $35.43 billion in fiscal year 2019. Once again, you can get a feel if the number is “good” by comparing it, both in dollar terms and on a percentage basis (i.e., as a percentage of revenues), to the values of its competitors' and Apple's own prior values. Gross profit minus (or less) selling, general, and administrative expenses is called operating income. It's what the company makes before paying taxes and other items that we'll briefly discuss. Accountants sometimes use a wordy substitute for operating income called earnings before interest and taxes, or EBIT for short. We'll stick with operating income. (You can thank us later.) Operating income is what the company makes on a regular basis, before taxes it pays to the government(s) and interest to its debtholders, from its regular course of business.

Hang in there, we're almost to the bottom line, and we mean that literally. We've included another item called “other” that is a catch-all term for anything outside the firm's regular course of business. It might include payments made to or received from business disputes, known as lawsuits or litigation. It might include interest income related to a firm's investments. It might include interest expense owed on a firm's loans or bonds. In Apple's case, it has a huge amount of cash and investments, more than $200 billion in fiscal year 2019, so the interest income item overwhelms everything else, and its “other” item is $1.60 billion in fiscal year 2019.

We mentioned the dreaded term “taxes” back in Chapter 1. They're basically payments to help fund the government. Taxes not only pay politicians' salaries, but they are also used for arguably more important items such as the armed forces (Army, Navy, Air Force, Marines, Coast Guard, etc.), maintaining the highway system, and for police and fire departments, plus thousands of other items. Even companies can't avoid taxes, at least most of the time, if they turn a profit.

The tax rate is the percentage of your income that you owe to the government. So if you make a $1,000 and you owe $100 to the government in taxes, your tax rate is $100 divided by $1,000, or 10%. Taxes are paid at the federal (e.g., Washington, DC) level and often at the state (e.g., New York) and occasionally at the local (e.g., New York City) level. We're just going to call it taxes and won't bore you with the details.

How much in taxes does a company pay? There are tax tables or tax schedules created by the government that provide specific information. The department of the federal government responsible for handling tax issues is the Internal Revenue Service (IRS). There are different levels or tax brackets for each amount of income that you or a company might earn. In general, as you make more money, you pay a higher tax rate. When tax brackets increase as you make more money, they are called progressive tax rates. Tax rates differ not only by state but also by country. Some territories or countries, such as Bermuda, charge no or minimal income taxes! Apple sells its products in many countries around the word, and its fiscal 2019 tax rate turned out to be a little bit more than 15%. In dollar terms, it amounted to a huge $10.22 billion. With those kinds of payments, many governments around the world should be huge fans of Apple too!

By taking operating income, adding other income, and subtracting income taxes, we finally arrive at net income, known as the “bottom line” in finance and accounting circles. Apple earned $57.53 billion in net income during fiscal year 2019. Way to go, Apple. That's a savage A+ grade!

Buffett suggests that one year of earnings is not too meaningful, especially for cyclical firms, or firms whose earnings vary widely with the business cycle. The analysis of a firm's financial earnings over a full business cycle, which typically lasts five-plus years, is called normalized earnings. In his 1983 Letter to Berkshire Shareholders Buffett wrote, “We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five-year test as a rough yardstick of economic performance.”

In his 1998 Letter to Berkshire Shareholders, he expressed even longer-term thinking, writing:

We give each a simple mission: Just run your business as if: (1) you own 100% of it; (2) it is the only asset in the world that you and your family have or will ever have; and (3) you can't sell or merge it for at least a century.

Let's wrap those thoughts up with a Tip and move on to the second major financial statement of a firm, the balance sheet, which is like a picture of the firm at a specific point in time.

The Balance Sheet: A Picture of a Company's Report Card Since Inception

Perhaps you or your friends like to take a lot of selfies and post them on Instagram, Snap, Facebook, or some other site. Well, a company has sort of a selfie. It's called a balance sheet. It's a snapshot or picture of what the company looks like at a certain point in time. Like with the income statement, the balance sheet is prepared by management on a quarterly basis and audited by an external CPA firm on an annual basis. Sometimes you'll see the balance sheet referred to as a statement of financial position or statement of financial condition. We're going to stick with balance sheet since it's the term used most often and also conveys some important information. That is, a balance sheet must balance. This is an important point to remember. We'll define what we mean by balance in a bit, so hang on.

A second way to view the balance sheet is that it is a sum of what the firm has become from its birth, or formation, to the present. In some respects, it's how the firm started, plus the results from all of its income statements. In this manner, it can be viewed like the sum total of all your grades since you started school. In college and most high schools, the sum of your grades is called a cumulative grade point average, or simply GPA. Most colleges compute your GPA on a 4-point scale. Thus, a 4.0 GPA means you got As in all of your classes since you entered school. Sweet!

Let's mix it up a bit and look at the December 31, 2019, balance sheet of Warren Buffett's firm, Berkshire Hathaway. Berkshire's calendar and fiscal year is the same, going from January 1 to December 31 of each year. Unlike the income statement, there are two sides to a balance sheet, a left side and a right side. This arrangement might seem a bit weird to you, but it has a long history. It actually goes back to the end of the 13th century! Man, that's old!

Way back then, a Florentine merchant named Amatino Manucci developed the notion of the balance sheet. The way the balance sheet is set up—that is, having the two sides—is also known as a double-entry form of bookkeeping. If something affects one side of the balance sheet, it usually has a corresponding effect on the other side of the balance sheet. Let's now describe what we mean by “sides.”

The items on the left-hand side of the balance sheet add up to an accounting term called assets or total assets. You can think of assets as the “stuff” the firm owns. Its cash, buildings, real estate, products, and so forth. The right-hand side of the balance sheet tells you who has claim to the “stuff.” Sometimes it’s people or banks that lent the firm money. Other times it could be the owners of the business, what we referred to as stockholders. The total of the left-hand side of the balance sheet has to equal the total of the right-hand side of the balance sheet. Always! If they don't, it would be like getting a 0 on an exam for the person or firm that prepared the balance sheet. Let's not even think about it!

So, getting back to Berkshire's balance sheet, we can see a simplified version of it in Figure 7.2. It has two sides to it, so it's a little more complex than the income statement. Let's start with the left-hand side, which we know is called total assets. Total assets are made up of two sections, current assets and long-term assets. Current assets are cash or things that are expected to turn into cash within one year (365 days). Long-term assets are things that have value but are unlikely to be converted into cash within one year. Let's get into some specifics related to Berkshire's business or, more accurately, businesses.

Figure 7.2

Berkshire Hathaway Balance Sheet (Simplified)
Period Ending December 31, 2019
Figures in $ millions
Current assets Current liabilities
Cash and short-term investments 127,997 Accounts payable 36,437
Accounts receivable 53,362
Inventory 19,852 Long-term liabilities
Long-term debt 99,425
Long-term assets
Property, plant & equipment 180,282 Other liabilities 257,076
Long-term investments 284,674 Stockholders' equity 424,791
Other 151,562
Total assets 817,729 Total liabilities plus
stockholders' equity
817,729

Current Assets

Looking at the current assets section you'll notice three items. Cash and short-term investments, accounts receivable, and inventory. You know what cash is. It's cash in your wallet, cash in a cash register, cash in a checking account, as well as some other things. The main thing to remember is that it's very safe. You can rely on it, at least as much as Steph Curry making a free-throw in a basketball game. “Cash is king” is a popular saying in the financial world. It means if you're cash rich, you have a lot of power, especially during economic downturns. Short-term investments are those that are about to expire or mature within one year, things such as US Treasury bills or commercial paper, which is short-term debt issued by corporations with a strong credit rating. These things are almost always considered very safe as well.

Accounts receivable is our next item under current assets. It might sound kind of strange, but you do have some familiarity with it, even if you don't know it yet. Sometimes is known as net receivables. Accounts receivable are sales made on credit, as from a credit card. Let's say you purchase from Dairy Queen a huge Oreo Cookies Blizzard® Treat. Yum! Assume the ice cream treat was paid for with a credit card. It will take a little bit of time, usually less than a month, for the credit card vendor, such as Visa, MasterCard, Discover, or American Express, to give Dairy Queen/Berkshire the cash. But it's a pretty safe asset in most cases, unless the company goes bankrupt. Not gonna happen in Berkshire's case!

The last item under current assets is inventory. Inventory is easy to visualize as the “stuff” the company has for sale before it's purchased by a customer. In Berkshire's case, it could be the ice cream in a Dairy Queen that has yet to be sold, it could be cans of paint in its Benjamin Moore stores, as well as thousands of other items. Inventory could also be raw material or work in progress, but it's easier to think about finished products. They can probably be sold for something within a year and likely have some value.

Long-Term Assets

Moseying on down to the left-hand side of the balance sheet we get to long-term assets. They refer to something that the firm owns that is of lasting value. These items are unlikely to turn into cash within a year. Property, plant, and equipment, or PP&E for short, is pretty much what it sounds like. First, it consists of land. Berkshire owns a lot of land, perhaps most noticeably in its railroad unit, Burlington Northern Santa Fe (BNSF). Berkshire bought the railroad for $26.5 billion back in 2010. It's easy to see why there is a moat around the business. They aren't building too many new railroads in the US, especially those that span much of the country.

BNSF is huge! It operates 32,500 miles of track across 28 states and has over 8,000 locomotives. For many items, such as barrels of oil found in the mid-continental United States, it is often cheaper to send them over rail rather than loading them on a truck. BNSF's history dates all the way back to 1849, so it's a business that has really stood the test of time, which is another feature3of many of Buffett's investments.

Plant usually refers to buildings built on pieces of land. It could be a factory, warehouse, office building, retail store, and a host of other things. Berkshire-owned Dairy Queen stores may be a Berkshire “plant” long-term asset you have visited in the past. Berkshire also owns the paint retailer Benjamin Moore. If you've ordered things such as balloons or napkins from your favorite sports team for a party, it may have come from Berkshire's toy and novelties unit, Oriental Trading Company. If you live on the West Coast perhaps you've been to a See's Candy store, another Berkshire company. You get the point; plant refers to places where work gets done. If the firm owns the real estate, it winds up on the PP&E portion of the balance sheet.

Let's tackle the “E” part, or equipment. Equipment is also easy to visualize. It refers to machines that produce the things a firm sells, such as a milkshake machine for Dairy Queen or a candy-making machine for See's Candy. It could be a truck that transports Berkshire's products to retail stores. Or a forklift in the factory. Even computers used by Berkshire employees. Machines usually last a long time, but they eventually break down. Think about a car. Tires lose their tread, brakes grind down, engines wear out, and so forth. Companies account for this wear and tear of a long-term asset with an accounting term known as depreciation. The life of an asset differs for various items, depending on how long it typically lasts. It might be 3 years for a computer, 5–7 years for a car, and 30 years for a building. We won't bore you with the details.

Next, we get to long-term investments. These represent Berkshire's investments in external, or third-party, firms or securities, such as the stock Berkshire holds in Apple, Coca-Cola, Wells Fargo, and Kraft Heinz. Although Berkshire owns billions of dollars of these firms' securities, it doesn't own a controlling interest. Controlling interest means Berkshire has the power to run the firm. That's why these investments are listed under the long-term investments field and not fully combined or consolidated into Berkshire's regular financial statements. In other words, if Berkshire owned a controlling interest in Coca-Cola, the beverage maker's revenues would be partially or fully included in Berkshire's revenues on its income statement. Since it doesn't own controlling interest, Berkshire's holdings are filed under the long-term investments section of its balance sheet.

The Other item in Berkshire's Assets includes a host of things, but we'll discuss one category called intangibles. Intangibles related to patents, trademarks, copyrights, and other items usually fall under the name, or umbrella, of intellectual property. Rules governing intellectual property prevent someone from stealing a firm's ideas or inventions. For example, if you were able to open up a store and call it McDonald's, you would instantly have a bunch of customers who know and love the food. Same goes for Disney, Nike, Apple, and many other companies. But you can't do this, of course, since someone else owns these firms and their related intellectual property.

The sum of the left-hand side of Berkshire's balance sheet totals to an amazing $817.729 billion. That's a lot of bread! Hang in there. We're half done with the balance sheet. Now let's shuffle over to the right-hand side of the balance sheet. It focuses on who has claims or dibs to the assets. These claimholders basically fall into two areas. First is the group that lent the firm money, or that provided it with products or services. In aggregate, this group is generally known as creditors. The second area is the owners, which we know are the stockholders. They get what's left over after paying all the bills. The gravy, so to speak. And with Berkshire's we'll see there is a whole lot left.

Liabilities

In everyday usage, a liability refers to a weakness. Maybe you've heard the expression “Achilles' heel.” Tom Brady is a great football player, but his liability is running for a gain, or scrambling in football lingo. NBA Hall of Famer, Shaquille O’Neal, was so bad at making free throws, that teams invented a strategy to try to beat him. It involved fouling him on purpose so he would have to shoot free throws, a strategy dubbed Hack-A-Shaq.

By now it should be clear that virtually everyone and everything has liabilities. As we noted above, a liability on the firm's balance sheet means it owes something to someone—an outside vendor, an employee, a bank, or a host of other creditors. As with the left-hand side of the balance sheet, we are going to break things into two categories, short term and long term. And short-term, or current, liabilities plus long-term liabilities equals total liabilities.

Current Liabilities

Current liabilities are amounts owed by the firm where payment is due within one year. Accounts payable is the flip side of accounts receivable. In this instance, Berkshire received a product or service and hasn't paid yet. A more generalized interpretation of accounts payable would also include paying the company's employees. Even Warren Buffett doesn't work for free! With most companies, employees work for 2 weeks or a month before receiving a paycheck. Berkshire had $36.437 billion in accounts payable at the end of 2019.

Long-Term Liabilities

Long-term liabilities represent money owed to creditors, but the money is due more than one year from today. In Berkshire's case, much of the money owed is to investors who bought Berkshire's bonds, to the tune of $99.425 billion! We also have an entry called “other.” It's a humongous number in Berkshire's case, $257.076 billion, so let's give an example of what might fall in this category. Berkshire has a big insurance unit as one of its businesses. Insurance protects you, by giving you money, if something bad happens to your car, property, or person. We mentioned GEICO before, one of the largest auto insurance firms in the world. Berkshire sells many other kinds of insurance, including life insurance.

Life insurance makes a payment to the surviving heirs (e.g., spouse or kids) of a person after they die. Many companies provide life insurance as one benefit, or perk, to their employees. Most of these workers are on the younger side and healthy. We mentioned in a prior chapter that a big chunk of the people who are on the earth today are going to live to be at least 100 years old, so it may be several decades before Berkshire has to pay death benefits on life insurance policies (i.e., long-term liabilities) even though it receives a policy payment (known as an insurance premium) on a regular basis. The money earned on the spread between the amount paid on an insurance policy and the premiums received by the insurance company is often called float. It's not quite as scrumptious as a root beer float, but you can do a lot of things with it. One option is to put it in a safe bank account and earn some interest. Buffett and Berkshire tend to be more aggressive with their float and invest much of it in stocks and other investments. Total liabilities for Berkshire added up to a whopping $392.938 billion at the end of 2019.

Stockholders' Equity

Now we get to the gravy, the icing, or what is left over after paying your bills. Accountants call it shareholders' equity, stockholders' equity, or owners' equity. Yet some other terms for the same thing are net worth or book value. Like the $80 billion or so Buffett is personally worth. Its calculation is a cinch, for either a company or a person. It's simply total assets minus total liabilities. In Berkshire's case it's a hefty $424.791 billion. And, of course, our balance sheet has to balance, so the sum of total liabilities and stockholders' equity equals the same $817.729 billion on the left-hand side, or total assets side, of the balance sheet.

Book value is listed on the balance sheet of a firm and it's something that can be measured by following accounting rules. We mentioned the term “intrinsic value” in the last chapter. It's an estimate of what the firm is worth today, or what we called a price target. Buffett distinguished between the two values in his 1993 Letter to Berkshire Shareholders, writing, “Of course, it's per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life.”

He goes on in that same letter with an analogy that describes book value as the cost of a college education, while intrinsic value is a measure of how much money a person will make over the course of their career. For example, a college student who becomes a engineer will likely make more money over their lifetime than a person that studied to be a social worker, even if their college education cost the same amount of money. Tip 30 focused on Buffett's preference for intrinsic value for evaluating the worth of a firm, so we won't create a duplicate tip here.

We don't want to confuse you, but the stockholders' equity value or book value is not necessarily equal to a firm's market capitalization, which we know is the price of firm's stock times its shares outstanding. For example, as we are writing this book, Berkshire's market value is a little bit over $500 billion while the stockholders' equity is roughly $425 billion. This happens to be the case for many firms, such as Facebook, Starbucks, Tesla, and indeed for the vast majority of firms. One reason for this difference is that the rules for creating financial statements tend to err on the conservative side. They record assets at cost. For example, if your grandparents bought an apartment in New York City or San Francisco 40 or 50 years ago, its price today would probably be much, much higher than what they paid for it. So when the market value is higher than the purchase price or book value, you can better understand this discrepancy.

Buffett likes to use the ratio of operating income to shareholders' equity as one measure of company performance. It's a measure of “bang for the buck,” or what the shareholders make from their regular course of business (the operating income), given the equity capital they have in the firm. He thinks the number should be greater than the average for the entire market over a five-year period and that a company shouldn't use too much debt or accounting gimmicks to get there.

Buffett criticized the approach of just looking for a company that has increasing earnings per share. A company can show rising earnings per share simply due to compound interest and not skill of management. For example, the cash balance of a company's bank account will increase, due to interest, pushing up earnings per share, other things equal. He expressed these thoughts in his 1979 Letter to Berkshire Shareholders, writing, “We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders' equity with all securities valued at cost is the most appropriate way to measure any single year's operating performance… . The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”

There's a lot of accounting terminology in Buffett's quote, but let's summarize these thoughts with a Tip.

In his 2009 Letter to Berkshire Shareholders, he drilled down further on the type of firms he likes. He wrote, “Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow.” Thus, a firm like See's Candy that generates high profits relative to the money invested in the business and that doesn't require a lot of new investment is the kind of firm that he's referring to here. In contrast, a car company such as GM or Ford has fairly low profit margins (i.e., profits as a percentage of sales) and requires investments in new car models, engines, transmissions, electric vehicles, and even “years down the road” investments in things such as driverless cars. Let's summarize Buffett's point with a Tip.

A Quick Note on the Statement of Cash Flows

There is a third major financial statement called the statement of cash flows that measures cash coming in and out of the business. It has three sections. The first section is cash flow from operating activities (CFO), which, as the name indicates, is cash generated from the firm's regular activities. For Berkshire, some element of CFO may be from selling insurance, candy, or ice cream. The second section is cash flow from investing activities (CFI), which refers to funds spent on long-term investments, such as PP&E and acquisitions of or investments in other firms. For Berkshire, it may include a new power plant, Dairy Queen store, or investment in Apple stock. The third section is cash flow from financing activities (CFF). This section includes things such as issuing or buying back equity or debt or the payment of dividends. The statement of cash flows can be derived from the income statement and balance sheet, but we'll leave the details aside for now. We sense you've probably had enough of accounting for the moment … or year.

Summary

You can trust that roughly 99-plus percent of the financial statements published by firms are accurate. By accurate we mean they are prepared under the rules of GAAP. Two of the main people running the firm, the chief executive officer and the chief financial officer, have to personally certify that the statements are true and accurate, or they risk going to jail. And, by the way, many people have gone to jail for falsifying financial statements. You can look up the names of Bernie Ebbers and Jeff Skilling if you want to learn about the high-profile financial fraud cases involving WorldCom and Enron. That being said, companies will try to put the best “spin” possible on their financial results while staying within the boundaries of GAAP. They often try to bury things in the footnotes that may not have yet affected the company's financial statements but may result in some bad news down the road.

Buffett is aware of these games that executives sometimes play with their financial numbers and wrote in his 1988 Letter to Berkshire Shareholders, “Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome. Too often their accountants willingly assist them. (‘How much,’ says the client, ‘is two plus two?’ Replies the cooperative accountant, ‘What number did you have in mind?’) Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance.” Let's include a Tip about being a bit wary with the reported numbers.

Accountants may seem nerdy. But Buffett embraces his inner nerdiness, and so should you. He spends much of his day reading financial reports. It can be pretty cool to have your financial house in order. It's one of our main goals in writing this book. And some basic knowledge of accounting and financial statements can help you do that. Berkshire's or Buffett's A+ balance sheet and income statement is a “stretch goal” worth aspiring to.

References

  1. “Apple Inc. (AAPL) Income Statement.” Yahoo! Finance. Accessed June 27, 2020. https://finance.yahoo.com/quote/AAPL/financials?p=AAPL.
  2. “Berkshire Hathaway Inc. New (BRK-B) Balance Sheet.” Yahoo! Finance. Accessed June 27, 2020. https://finance.yahoo.com/quote/BRK-B/balance-sheet?p=BRK-B.
  3. “BNSF Railway—News, Reports & Features for Rail Industry Professionals.” Progressive Railroading. Accessed June 27, 2020. https://www.progressiverailroading.com/bnsf_railway/.
  4. Buffett, Mary, and David Clark. Warren Buffett and the Interpretation of Financial Statements The Search for the Company with a Durable Competitive Advantage. London: Simon & Schuster, 2011.
  5. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 1979. https://www.berkshirehathaway.com/letters/1979.html.
  6. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 1983. https://www.berkshirehathaway.com/letters/1983.html.
  7. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 1986. https://www.berkshirehathaway.com/letters/1986.html.
  8. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 1988. https://www.berkshirehathaway.com/letters/1988.html.
  9. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 1993. https://www.berkshirehathaway.com/letters/1993.html.
  10. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 1998. https://www.berkshirehathaway.com/letters/1998.html.
  11. Buffett, Warren. “Letter to Shareholders of Berkshire Hathaway Inc.” Berkshire Hathaway, Inc., 2009. https://www.berkshirehathaway.com/letters/2009.html.
  12. CNBC. “Warren Buffett's Advice to Teen Investor,” July 31, 2014. https://www.cnbc.com/video/2014/07/31/warren-buffetts-advice-to-teen-investor.html.
  13. Penman, Stephen H. Financial Statement Analysis and Security Valuation. New York: McGraw-Hill Higher Education, 2013.