In the third section of their book, “Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage,” authors Mary Buffett and David Clark discussed the format of cash flow statements and explained this
Warren Buffett (Trades, Portfolio) is looking for it.
As for what Buffett is looking for, they give us a clue in this quote from the guru at the top of the chapter: “There is a huge difference between the business that grows and requires a lot of capital to do so and the business that grows. and does not require capital.
Also at the top of the chapter, an explanation of the rationale for the cash flow statements. It revolves around the two methods of recognizing that a business has recorded new income. Using the cash method, recognition takes place when the money actually arrives; under the accrual method of accounting, posting takes place when goods arrive in the hands of customers but have not yet been paid for.
Since most companies grant loans, they prefer to use the accrual method of accounting, which allows them to recognize their income sooner. Because of this discrepancy between when the income is recognized and when the money arrives, the accountants created the cash flow statement. It also helps to track the amount of investment or debt that entered or left the company in a specific quarter or year.
The first section of the cash flow statement deals with Operating Activities:
As shown, this is calculated by adding depreciation and amortization to net income. Neither depreciation nor amortization requires current cash flow because it represents cash spent earlier.
The second section presents the cash flows from investments. This takes into account all capital expenditure (capex) during the period in question. This number must be negative because it is an expense, which takes money:
Third, there is cash flow of funding. It includes the inflows and outflows of money from the purchase or sale of own shares, redemptions and dividends. Selling corporate bonds makes money, buying them brings money out:
Finally, all these activities are added together to produce the net change in cash:
That concludes the section on the format and we move on to Buffett’s approach to the statement of cash flows. While he undoubtedly reads closely, there are a few areas that receive special attention.
The first is capital expenditure, which represents cash used for relatively permanent assets, assets that last longer than a year. For example, when a business buys a truck, it incurs a capital expenditure, but not the gasoline used to power the truck.
Capital expenditure generally relates to the tangible fixed assets of traditional goods-producing enterprises. For tech companies, on the other hand, it can be the cost of purchasing intangibles like patents. As the various sections of the cash flow statement suggest, a business makes a capital expenditure to purchase an asset and then depreciates or amortizes that cost in subsequent years.
Certain types of businesses require more or less investment than other types of businesses. For example, the authors say that Buffett didn’t invest in the phone companies because they need huge amounts of capital to keep up with their competition.
He expects companies with sustainable competitive advantages or a strong divide won’t need such large investments. Here are a few companies that illustrate this contrast, since the book’s publication in 2008:
- Coca Cola (KO, financial) used 19% of its total income for capital expenditures.
- Moody’s (AGC, Financial) only needed 5% of total income for capital expenditure.
- Good year (GT, Financial) used around 950% of its profits on capital expenditures.
As for struggling companies like Goodyear, they spent far more than their profits, so the void had to be filled with bank loan debt and the sale of bonds to the public.
For companies like Coca-Cola and Moody’s, their low capital spending allowed them to buy back stocks and take other actions, including paying down debt.
Keep in mind that investors should look at 10-year cash flow statements when analyzing the relationship between net earnings and capital expenditures. This allows them to look beyond variations of one or a few years.
Buffett uses a few obstacle rates in this analysis:
- A business that uses 50% or less of its annual net income for capital expenditures deserves to be vetted for lasting competitive advantage.
- If that number is 25% or less, there’s a good chance the company has a gap.
The other key area for Buffett is share pulling, more informally known as share buybacks. When businesses have strong competitive advantages, they often waste more money than they can use effectively. If they don’t want to sit on that money or make acquisitions, they can either issue dividends or buy back shares.
Buffett is a big fan of companies that buy back stocks rather than pay dividends. There is a simple reason for its preference: redemptions are not taxed, while dividends are. In addition, capital gains taxes must be paid when an asset is sold, but if you rarely sell, as has been the practice at Berkshire Hathaway (BRK.A, Financial)(BRK.B, financial), you rarely pay taxes.
Redemptions also increase the proportional interest of each remaining shareholder. Fewer shares mean fewer claimants on a company’s profits and, therefore, each remaining shareholder gets a bigger slice of the pie.
Either way, more money stays in investors’ pockets and this speeds up the pace of capitalization. When compounding occurs within a company, its intrinsic value increases and other investors are willing to pay a higher price to buy its shares. This has been one of the great secrets of Berkshire Hathaway, who has grown so much under the wise leadership of Buffett and his colleague.
Charlie munger (trades, portfolio).
Disclosure: I do not own any shares in any listed company and do not expect to buy any in the next 72 hours.
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