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April 16, 2019 | About: WFC +0% BAC +0% GM +0% F +0% MCO +0% BRK.A +0% BRK.B +0% KO +0%
Buffett on Financial Statements: Balance Sheet LiabilitiesA closer look at the relationship between debt and durable competitive advantage
Robert Abbott
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After dealing with the income statement and balance sheet assets in their book, “Warren Buffett andthe Interpretation of Financial Statements: The Search for the Company with a Durable CompetitiveAdvantage,” authors Mary Buffett and David Clark turned to the liabilities side of the balance sheet.
That current liabilities section of the statement looks like this:
“Current” refers to debts and other obligations that must be met within the fiscal year.
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Again, the authors were looking at them as a tool for discovering durable competitive advantages.Such moat-like qualities are found in some line items:
Accounts payable and accrued expenses
This category covers what a company owes its suppliers for raw materials, inventory and the like. Inother words, the goods have been delivered, but the bill, or a portion of it, has yet to be paid.Accrued expenses refers to liabilities created but not yet paid; they include sales taxes, wages andrent payments. This category also includes “other debts” that cover short-term liabilities that don’tfit into the other two categories. Generally, Warren Buffett (Trades, Portfolio) does not see muchbeyond numbers here.
Short-term debt
Including commercial paper and short-termdebt, this line item refers to obligations duewithin one year. For financial firms, there isalways the opportunity to leverage thedifference between short-term and long-termdebt: Borrow short term at say 5% and lend
long term at 7%. But it did not work out so well for Bear Stearns and thousands of lesser-knowncompanies throughout financial history. It also explains why Buffett likes Wells Fargo (NYSE:WFC),which had 57 cents of short-term loans for every dollar of long-term debt, compared to Bank ofAmerica (NYSE:BAC), which had $2.09 at the time of publication. Wells Fargo is far moreconservative than Bank of America, and much more likely to survive a downturn.
Long-term debt due
This is the portion of a long-term debt that becomes due each year. Buffett expects companies witha durable competitive advantage, a moat, will need little or no long-term debt to maintain or growtheir operations. All investors should be concerned about companies that include current long-termdebt commitments with their short-term debt. Beware, too, of too much long-term debt coming duein a single year.
Other current liabilities
The authors wrote nothing for this section, but usually it refers to liabilities that do not fit into thecategories above, but like them are due in the next year. Presumably, Buffett does not see anyinsights arising out of this section.
Total current liabilities and the current ratio
Total current liabilities is the total of all the short-term obligations and the portion of long-term debtcoming due in the next year.
The authors focus on the current ratio, which provides an indication of a company’s liquidity. It iscalculated by dividing total current assets by total current liabilities; a ratio of more than one is agood sign, while a ratio of less than one suggests a company may have trouble meetings its
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Symbol Company CurrentPrice Change (%) Gain
(%) P/E
AGN Allergan PLC $ 138.59 -6.82 (-4.69%) -43.17% 0.00
BAX Baxter International Inc $ 74.61 -3.01 (-3.88%) 34% 24.96
HUM Humana Inc $ 227.23 -7.87 (-3.35%) 2.37% 18.71
LLY Eli Lilly and Co $ 116.56 -3.40 (-2.83%) 43.3% 37.71
CMG Chipotle Mexican Grill Inc $ 688.60 -17.88 (-2.53%) 44.37% 108.94
AMGN Amgen Inc $ 183.63 -4.42 (-2.35%) 13.17% 14.56
JPM JPMorgan Chase & Co $ 113.13 2.03 (1.83%) 30.03% 12.60
AAPL Apple Inc $ 202.81 3.56 (1.79%) 44.16% 17.92
SHW Sherwin-Williams Co $ 444.05 -6.42 (-1.43%) 32.68% 38.08
ARCH Arch Coal Inc $ 89.89 1.03 (1.15%) 27.94% 5.86
Summary -1.63% 22.89% 27.93
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financial obligations.
Yet many companies with durable competitive advantages have current ratios of less than one.Why? Because these companies have “immense” earnings power and usually don’t require thesame “liquidity cushion” as marginal or average businesses. So we should not expect the currentratio to give us reliable indications about a company’s moat.
That covers current liabilities, but, of course, there are also non-current liabilities that must berecognized on the balance sheet:
Long-term debt
This refers to obligations due more than a year ahead, and is a category Buffett takes very seriously.The type of companies he looks for, with durable competitive advantages, usually have little or nolong-term debt. They generate earnings that are more than enough to self-finance their expansions,acquisitions, buybacks or dividends.
Consider these comparisons: strong-moat companies Coca-Cola (NYSE:KO) and Moody’s(NYSE:MCO) could, at the time of publication, pay off their long-term debt in a single year. On theother hand, automakers and no-moat companies General Motors (NYSE:GM) and Ford (NYSE:F)would need more than 10 years to pay off their high levels of long-term debt. We know whereBuffett has invested his money, which is to say that of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B).
Deferred income tax, minority interest and other liabilities
These are the last three lines in the long-term section of liabilities. Deferred income tax is relativelystraightforward and provides little information about durable competitive advantages.
The minority interest line is a complex one: For example, when Berkshire Hathaway boughtNebraska Furniture Mart, it acquired 90% of the shares. According to accounting rules, though,Berkshire could book 100% of Nebraska Furniture Mart’s income on its balance sheet, along withthe assets and liabilities. Minority interest on the balance sheet reflects the 10% of NebraskaFurniture Mart that Berkshire did not buy.
Other liabilities may include obligations such as judgements against the company, non-currentbenefits and derivatives. Again, there is no help in identifying durable competitive advantages.
Total liabilities and the debt-to-equity ratio
Total liabilities is the sum of current and non-current liabilities, essentially everything a companyowes from tomorrow until years into the future.
It also provides data for the debt-to-(shareholders’) equity ratio. Typically, it was used to help figureout whether a company was using debt or equity to finance its operations. In theory, at least,
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companies with a durable competitive advantage will have enough earnings power for theiroperations and expansion so they have little need for debt and other liabilities. But once again,companies with strong moats defy the meaning of the debt-to-equity ratio. Given their earningspower, they need little or no equity (or retained earnings) on their balance sheet. Instead, they canbuy back shares, make acquisitions or issue dividends with their earnings.
For example, at the time of publication, Moody’s, a company with a durable competitive advantage,required no shareholders’ equity on its books, so it used that cash to buy back shares. And itbought back so many shares it had negative shareholders’ equity. That meant its debt-to-equityratio looked like that of General Motors, which has no durable competitive advantage.
Once again, financial institutions are an outlier since they are in the business of borrowing andlending money.
As with the income statement and assets section of the balance sheet, Buffett uses the liabilitiessection to help find outstanding companies with durable competitive advantages.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72hours.
Read more here:
Buffett on Financial Statements: Balance Sheet Assets
Buffett on Financial Statements: The Income Statement
Buffett on Financial Statements: A Window Into Warren's Mind
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About the author:
Robert AbbottRobert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options-- mainly covered calls and collars with long stocks.
He is a freelance writer, and his projects include a website that provides information for new andintermediate-level mutual fund investors (whatisamutualfund.com).
As a writer and publisher, Abbott also explores how the middle class has come to own bigbusiness through pension funds and mutual funds, what management guru Peter Drucker calledthe "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?"he looks at the ownership of McDonald’s and what it means for middle-class retirement income.
Visit Robert Abbott's Website
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