Warren Way of Analyzing Profit & Loss Statement

What is a Profit and Loss Statement (P&L)?

The profit and loss statement is a financial statement that summarizes the revenues and costs incurred during a specific period. The P&L statement is synonymous with the income statement. These records provide information about a company’s ability or inability to generate profit by increasing revenue, reducing cost or both.

 

Understanding how to analysis P&L Statement

The P&L statement is one of the three financial statements every company issues quarterly and annually. It is often the most popular statement that investors analyses before investing in a company. But how should one analyze P&L statement? The book “Warren Buffet and Interpretation of Financial Statements” guides us how Warren analyzes P&L Statement to identify company with durable competitive advantage.

Without further ado, here is a summary of the book

 

1) Revenue : Where money comes in

The first line of P&L Statement tells us about total gross revenue of the business. It is the amount of money that came into the business during a particular period. Does lot of revenue mean lots of earnings? NO. Revenue on standalone basis does not tell us much about a business. So, it is necessary to deduct expenses from revenue.

2) Cost Of Goods Sold (COGS): For Warren Lower the Better

COGS refers to the direct cost of producing the goods sold by the company. It includes direct material and labor cost involved in manufacturing product. Although, COGS as a lone number, does not tell us much about the company. It is essential to deduct COGS from revenue to check whether the company has durable competitive advantage.

 

3) Gross Profit Margin: Key Number in Search Of New Gold

Gross Profit Margin is the money the company made off total revenue after deduction cost of raw materials and labor used to make goods. It should be large enough to over operating expense.

Compare gross profit margin over a long period of time say 8-10 years. Check for consistent and steady rise in gross margin. A rise in gross profit margin indicates economics of scale. Warren considers that gross profit margin of 40% or better indicates that the company has some sort of durable competitive advantage. Gross profit margin of less than 40% indicates that the company is in competitive industry and such companies cannot make us rich. Gross profit margin test is one of the early indicators of company with durable competitive advantage.

  

4) Selling, General & Administrative Expense (SG&A): Where Warren Keeps a Careful Eye

SG&A expense includes all everyday operating expense of the business that are not included in COGS. It includes rent, advertising, marketing, employee cost etc. Calculate SG&A as a percentage of total gross profit.

Compare SG&A as a percentage of gross profit over a long term. If there are huge variation in this over year, it means that company is facing fierce competition. Ideally, SG&A as a percentage of Gross Profit should remain consistent over years. Warren considers that ratio less than 30% indicates a fantastic business. However, anything between 30-80 is considered good. Ratio greater than100 indicates competitive industry.

 

5) Research and Development: Why Warren Stays Away from It

Warren Buffett stays away from company that heavily invest in R&D. Yes, you read it correct! Warren Buffet considers such company as an inherent flaw in their competitive advantage. If competitive advantage arises because of technological advancement, there is always a threat that new technology will replace it. Today's competitive advantage can become tomorrow's obsolescence. If a company has competitive advantage due to patent, its competitive advantage will die once the patent expires.

 

6) Depreciation: A Cost Warren Cant Ignore

Warren Buffett strongly disagree with the investors who gives more importance to EBITDA (Earnings Before Interest Tax Depreciation and Amortization) while investing and ignores depreciation. He urges that one day the assets are going to wear out and the company will have to buy new assets. Hence, it is necessary to include depreciation in our analysis. Warren has identified that companies with durable competitive advantage tend to have depreciation cost lower than 10% of gross profit.

 

7) Interest Expense: What Warren Doesn’t Want

Interest expense arises because of debt the company carries on its balance sheet as liability. Companies with high interest payment as a percentage of operating profit is mainly due to two reason: A company is in fiercely competitive industry where large capex is required or a company that acquired debt when the company was bought in a leveraged buyout. Warren has identified that companies with durable competitive advantage tend to have interest cost less than 15% of operating profit. Lower the ratio better the competitive advantage.

 

8) Exceptional Item: What Warren Ignores

Exceptional item includes irregular gain or loss on some transaction. For example, gain or loss on sale of asset. Such transaction can significantly add or subtract to company’s bottom line. Since, they are non-recurring events, Warren says that we should remove them from net profit calculation.

 

9) Net Earnings: What Warren is Looking For

After all the expense and taxes have been deducted from company’s revenue, we get company’s net earnings. Warren’s checklist includes whether the net earnings are showing historical upward trend. A single year’s net earnings are worthless as it is important to check consistency of earnings. Net earnings greater than 20% of total revenue indicates that the company has a competitive advantage. Net earnings less than 10% of total revenue indicates that the company is in competitive industry. A company having net earnings between 10-20% of total revenue, is a business ripe for mining long term gold that no one has discovered yet.

 

10) Earnings Per Share: How Warren Tells the Winners from The Losers

Earnings per shares indicates how much a company earns per outstanding share. This is an important number in world of investing as more the company earns per share, higher will be its stock price.

Warren looks for consistent and steady in EPS over long period. Consistent upward trend indicates that company’s economics are strong enough to allow them to increase their earnings.

Final words:

Warren Buffett considers P&L statement as a primary source of indication of company's durable competitive advantage. Along with P&L statement, an investor should also analyze balance sheet, cashflow statement and do his own exhaustive research before investing in a company.

Happy Investing!

Disclaimer: Companies used as an example in this blog are for educational purposes and not an investing advice.