Warren Buffett has been analyzing businesses for more than 80 years. Over that time, he's read thousands of annual reports and has analyzed a balance sheet countless times. That experience has allowed him to create five investing rules of thumb that allow him to analyze any balance sheet in just a few seconds.
In this video, I'll explain Buffett's five rules of thumb and show you how Chipotle's balance sheet stacks up against them. Hi, my name is Brian Feroldi. I'm a financial educator who's been analyzing and investing in businesses for more than 20 years. Let's get started. First, let's make sure we all understand what a balance sheet is.
A balance sheet is one of the three major financial statements that shows everything a company owns and owes to others. The balance sheet is ruled by the master account equation that states that assets must always equal liabilities plus... shareholders' equity. These two parts of the equation must always be in perfect balance, hence the name of the balance sheet. Now, when it comes to analyzing a balance sheet, Buffett has five main rules of thumbs that he looks for.
Rule of thumb number one relates to the company's cash balance versus its debt. Formula here is quite simple. You just take the company's cash and cash equivalents and compare them to the company's debt.
His rule of thumb is that a company has more cash than debt. So when looking at a balance sheet here, we would take the company's cash and marketable securities, which is $3,000, $3,000. Compare them to the company's debt, which is $2,000.
In this case, this company has more cash than debt, which would pass his rule. Why did Buffett invent this rule? Well, he likes to invest in companies that are so good at producing cash that they don't need to use any debt at all to run the business. So if he sees a business that has more cash than debt, that's a positive sign.
Buffett's rule of thumb number two relates to the company's debt to equity ratio. The formula here is quite simple. You take the company's total liabilities and you divide it by shareholders' equity.
Buffett wants to see this number below 0.8. So when looking at this company, its total liabilities is $4,000. We would take that and we would divide it by the company's total equity, which in this case is $12,000.
That would give us a debt to equity ratio of 0.33, which is below Buffett's 0.8 figure. Now what does this rule of thumb mean? Well, Buffett likes to invest in companies that produce so much cash that they finance themselves with equity, not with debt.
When a company has a debt-to-equity ratio below 0.8, that tells him that the company has financed itself with equity and has largely been able to avoid debt. Rule of thumb number three relates to preferred stock. The formula here couldn't be simpler.
The preferred stock equals zero. So his rule of thumb is that a company does not have any preferred stock on its balance sheet. Now every balance sheet you see will have its own layout and terms, but generally speaking, preferred stock will be one of the first line items that you see in shareholders' equity.
In this case here, this company does not have any preferred stock listed, which would be a good thing in Buffett's eye. Now why does Buffett have this rule of thumb in place? Well, preferred stock is a bit of a hybrid between debt and equity.
And generally speaking, strong companies never have to issue preferred stock to fund themselves. So Buffett wants to see that a company does not have any preferred stock at all, which indicates to him that the company is a financial powerhouse. That brings us to rule of thumb number four, which is about retained earnings, and specifically retained earnings growth. Buffett likes to compare a company's retained earnings in the most recent period to the retained earnings in the last period. And his rule of thumb is that this number consistently grows, especially during recessions.
Now, to find this number, we simply look in the shareholders equity section of the balance sheet for a figure that's called retained earnings. We want to see that this figure is positive and is larger than the same figure in the year ago period. Now, why does he have this rule of thumb in place?
Well, if retained earnings is growing, that means that the company is producing profits and it's also keeping a portion of that profits to reinvest in the business. So if this number is consistently growing, especially during periods of economic stress, that is a very strong sign for investors. Okay, rule of thumb number five relates to the company's treasury stock.
So the rule of thumb here is that the company has some treasury stock. Now, treasury stock is found in the shareholders' equity portion of the balance sheet, and in this case, it's listed as zero. But what is treasury stock?
Treasury stock is simply the cumulative amount of stock buybacks that a company has repurchased from its shareholders. So Buffett wants to see that this figure is positive, which indicates to him that the company is returning capital to shareholders through stock buybacks. Now, I just threw a bunch of information at you, but I also made a simple PDF download that has all of Warren Buffett's financial statement rules of thumb on them.
If you want a free copy, just visit longtermmindset.co backslash Buffett or click the link in the video description. Now that we know Buffett's rules of thumb, let's take a look at a real balance sheet to see these rules of thumb in action. In this case, I'm going to take a look at Chipotle's balance sheet to see these numbers in action. So I've loaded Chipotle's stock symbol CMG into FinChat. And if I scroll down, I click on balance sheet, and here we have the company's balance sheet listed.
Now, in the most recent period, this company had about $1.42 billion in cash and short-term investments on its balance sheet. That's quite good. But how does that compare to the company's debt level? Well, I'm going to click over to the company's liabilities, and if I scroll my eyes down here, I actually don't see the word debt listed anywhere. That tells me that this company has a debt-free balance sheet.
So when it comes to rule of thumb number one, this company has tons of cash, zero debt, it passes Buffett's test. That brings us to rule of thumb number two, the company's debt-to-equity ratio. Now to locate this number, I'm going to go to FinChat, scroll down to the ratios tab, and then click on financial health. Down here, I'm going to see the company's debt-to-equity ratio.
which is currently 1.2. Now as a reminder, Buffett wants to see this figure below 0.8. So on this test, the company fails.
However, this is where some nuance needs to be applied. Remember that the debt to equity ratio takes the company's total liabilities and divides by the company's total equity. If we look at the company's total liabilities, they're $5 billion. However, the company's largest liability is actually this, long-term leases of $3.9 billion.
Now, personally, I don't view this number as a problem on a company's balance sheet. It simply means that Chipotle has signed some leases, and it's going to need to pay that rent in the years ahead. So while some calculators consider this to be debt, I do not. So that's thing number one. Thing number two is if we click over to the company's equity section, we'll notice that this company only has $3.3 billion in total equity.
However, we see that the company's treasury stock, which is stock that it has repurchased from shareholders, is negative $5 billion. That is actually pulling this number down. So if we adjust for the company's long-term leases and its treasury stock, the company's debt-to-equity ratio would actually be far below the 0.8 figure.
So while you might disagree with me, I am personally going to give this company a check on this figure. The next number here to look at is preferred stock, and we want to see if this company does not have any. So in FinChat, we scroll down to the balance sheet, we click over to equity, and we're looking for the word here to be preferred stock. Now, I don't see that word anywhere on here, which means that Chipotle does not have any preferred stock.
That's exactly what Buffett wants to see, so I would give this figure a check as well. The fourth number on Buffett's rules of thumb is retained earnings growth. We want to track how this company's retained earnings have been progressing over the last couple of years.
Now, on FinChat, retained earnings is kept in the balance sheet and then equity section, and we can actually click this number right here. FinChat will actually automatically graph this figure, and what we can see is that this number is consistently growing. In fact, if we widen this out to a longer time period, we can see that Chipotle has consistently grown its retained earnings for many years in a row, including during 2020 and 2021, which were challenging periods for a lot of companies, especially restaurants.
For that reason, Chipotle passes this test too. The final number here to look at is the company's treasury stock, which is the Q1 amount of stock buybacks. Buffett wants to see that this treasury stock number exists.
Now, treasury stock can be found in the balance sheet and then equity portion. And as we saw before, this company has spent more than $5 billion buying back stock, and this figure has actually increased over the year. Now, it's recorded as a negative number, but this just means that the company has actively bought back stock from investors.
So when thinking about Buffett's rule of thumb checklist, Chipotle passes this test too. So there you have it. Knowing these five simple balance sheet rules of thumb can make it much easier for anyone to analyze a balance sheet.
If this video was helpful, give it the like button and let me know in the comment section below. See you in the next video. Brian, out.