Overview

This lecture explains Warren Buffett's five key rules for quickly analyzing a company’s balance sheet and demonstrates their application using Chipotle as an example.

Understanding the Balance Sheet

• A balance sheet lists a company’s assets, liabilities, and shareholders’ equity.
• The accounting equation: Assets = Liabilities + Shareholders’ Equity.
• The balance sheet must always be in balance due to this equation.

Buffett’s Five Balance Sheet Rules

• Rule 1: Cash vs. Debt – A company should have more cash (including equivalents) than total debt.
• Rule 2: Debt-to-Equity Ratio – Total liabilities divided by shareholders’ equity should be below 0.8.
• Rule 3: Preferred Stock – The company should have zero preferred stock on its balance sheet.
• Rule 4: Retained Earnings Growth – Retained earnings should show consistent growth across periods, even during recessions.
• Rule 5: Treasury Stock – The company should have treasury stock, indicating regular stock buybacks.

Applying the Rules to Chipotle

• Chipotle has $1.42 billion in cash and no debt, passing the cash vs. debt test.
• Its reported debt-to-equity ratio is 1.2, but adjusting for leases and treasury stock, it effectively meets Buffett’s criteria.
• Chipotle has no preferred stock listed, passing rule 3.
• Retained earnings have grown consistently over several years, including difficult periods, satisfying rule 4.
• Chipotle’s treasury stock shows more than $5 billion in buybacks, passing rule 5.

Key Terms & Definitions

• Balance Sheet — Financial statement showing assets, liabilities, and shareholders' equity at a given time.
• Debt-to-Equity Ratio — Total liabilities divided by shareholders' equity; measures financial leverage.
• Preferred Stock — Hybrid security between debt and equity; often avoided by strong companies.
• Retained Earnings — Profits kept in the business instead of distributed to shareholders.
• Treasury Stock — Company shares repurchased from shareholders, reducing outstanding shares.

Action Items / Next Steps

• Review Buffett’s five rules and apply them to other company balance sheets for practice.
• Optional: Download the summary PDF for Buffett’s balance sheet rules from the provided link.

Certainly! Here's a step-by-step guide with calculations for applying Warren Buffett's five balance sheet rules of thumb, using the example of a company like Chipotle:

Step 1: Cash vs. Debt

Goal: Check if the company has more cash (and equivalents) than total debt.

Formula:
Compare
Cash + Marketable Securities
to
Total Debt

Calculation Example:

• Cash and equivalents = $1.42 billion
• Debt = $0 (Chipotle has no debt)

Result:
$1.42 billion > $0 → Passes Rule 1

Step 2: Debt-to-Equity Ratio

Goal: Ensure the debt-to-equity ratio is below 0.8.

Formula:
[ \text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}} ]

Calculation Example:

• Total liabilities = $5 billion (includes $3.9 billion long-term leases)
• Shareholders' equity = $3.3 billion (adjusted by treasury stock)
• Treasury stock = $5 billion (repurchased shares, reduces equity)

Adjustments:

• Exclude long-term leases from liabilities if you consider them operating leases, not debt.
• Adjust equity by adding back treasury stock (since treasury stock reduces equity).

Adjusted Calculation:

• Adjusted liabilities = $5 billion - $3.9 billion = $1.1 billion
• Adjusted equity = $3.3 billion + $5 billion = $8.3 billion

[ \text{Debt-to-Equity Ratio} = \frac{1.1 \text{ billion}}{8.3 \text{ billion}} \approx 0.13 ]

Result:
0.13 < 0.8 → Passes Rule 2 (after adjustment)

Step 3: Preferred Stock

Goal: Confirm the company has zero preferred stock.

How to check:
Look in the shareholders' equity section of the balance sheet for any preferred stock line item.

Example:

• No preferred stock listed for Chipotle.

Result:
Preferred stock = 0 → Passes Rule 3

Step 4: Retained Earnings Growth

Goal: Retained earnings should consistently grow over time, including during recessions.

How to check:

• Find retained earnings in shareholders' equity for the current and previous years.
• Compare the figures year-over-year.

Example:

• Retained earnings have increased every year, including during 2020 and 2021.

Result:
Consistent growth → Passes Rule 4

Step 5: Treasury Stock

Goal: The company should have treasury stock, indicating stock buybacks.

How to check:

• Look for treasury stock in shareholders' equity (usually a negative number).

Example:

• Chipotle has $5 billion in treasury stock (negative value).

Result:
Treasury stock exists → Passes Rule 5

Summary Table

If you'd like, I can help you apply these steps to another company or explain any part in more detail!