Lecture Notes: Warren Buffett’s Balance Sheet Analysis Rules

Introduction

• Warren Buffett’s 80+ years of experience in analyzing businesses.
• Emphasis on analyzing balance sheets using five rules of thumb.
• Example provided using Chipotle’s balance sheet.

Understanding the Balance Sheet

• One of three major financial statements.
• Shows what a company owns (assets) and owes (liabilities).
• Governed by the accounting equation: Assets = Liabilities + Shareholders' Equity.

Buffett's Five Rules of Thumb for Analyzing Balance Sheets

1. Cash vs. Debt

• Rule: Company should have more cash than debt.
• Reason: Indicates strong cash production without reliance on debt.
• Example Calculation:
  • Cash & Marketable Securities: $3,000
  • Debt: $2,000
  • Result: Passes rule (more cash than debt).

2. Debt to Equity Ratio

• Rule: Ratio should be below 0.8.
• Formula: Total Liabilities / Shareholders’ Equity.
• Reason: Indicates financing through equity, not debt.
• Example Calculation:
  • Total Liabilities: $4,000
  • Shareholders’ Equity: $12,000
  • Debt to Equity Ratio: 0.33 (passes rule).

3. Preferred Stock

• Rule: Preferred stock should equal zero.
• Reason: Indicates financial strength without needing hybrid financing.
• Example: No preferred stock listed, meets Buffett’s criteria.

4. Retained Earnings Growth

• Rule: Retained earnings should consistently grow.
• Reason: Reflects profitable reinvestment during economic stress.
• Example: Positive and growing retained earnings, especially during recessions.

5. Treasury Stock

• Rule: Company should have treasury stock.
• Reason: Shows capital returned to shareholders via buybacks.
• Example: Treasury stock exists, indicating active stock buybacks.

Case Study: Chipotle’s Balance Sheet

Evaluation Against Buffett’s Rules

1. Cash vs. Debt
   • $1.42 billion in cash, no listed debt. Passes.
2. Debt to Equity Ratio
   • Listed as 1.2, fails initially.
   • Adjusting for long-term leases and treasury stock lowers ratio.
   • Personal judgment: Passes.
3. Preferred Stock
   • No preferred stock listed. Passes.
4. Retained Earnings Growth
   • Consistent growth over years, including 2020-2021. Passes.
5. Treasury Stock
   • Over $5 billion in buybacks, recorded as negative number. Passes.

Conclusion

• Understanding and applying these five rules simplifies balance sheet analysis.
• Example showed Chipotle largely meets these criteria.
• Encouragement to apply these rules when analyzing other companies.
• Reminder to access additional resources for further learning.