How to read the income statement like Warren Buffett

What is the Income Statement?

The income statement is one of the main financial statements that investors look at when evaluating a company. It shows the company's revenue, expenses, and profit or loss over a specific period, such as a quarter or a year. By looking at this statement, investors can see how much money a company is bringing in from its operations and what it’s spending to earn that revenue.

For Warren Buffett, the income statement is essential to understand the economic engine of a company. It provides insights into whether the business is profitable and, more importantly, if it has a lasting advantage over its competitors. Unlike short-term earnings, Buffett focuses on the company’s ability to generate sustainable profits over the long term. This focus helps him find companies with a “durable competitive advantage”—those that can keep performing well despite market competition.

In short, the income statement is a crucial tool for investors, especially those who want to evaluate a company's long-term potential and stability. It’s not just about whether the company made a profit but understanding the sources and stability of those profits over time.

What is Revenue and How Does Warren Buffett Interpret It?

Revenue, often called total or gross revenue, is the first line on an income statement. It represents the total amount of money a company earns from selling its products or services over a specific period, whether quarterly or yearly. For example, if a shoe company sells $120 million worth of shoes in a year, its revenue for that period is $120 million.

However, high revenue doesn’t necessarily mean a company is profitable. To find out if it’s actually making money, we need to look at the expenses. Revenue minus expenses gives us the net earnings, which show the true profit. Revenue alone doesn’t tell the full story until we understand how much was spent to generate it.

For Warren Buffett, revenue is just the starting point. Once he reviews it, he digs deeper into the expenses to understand how efficiently the company operates. Buffett believes that one of the keys to increasing profit is controlling expenses. In other words, making more money often comes down to spending less. This focus helps him identify businesses that aren’t just generating high sales but are also managing costs effectively to achieve long-term profitability.

What is COGS and How Does Warren Buffett Interpret It?

Right below the revenue line on the income statement, you’ll find the Cost of Goods Sold (COGS), also known as the Cost of Revenue. COGS represents the direct costs associated with producing the products or services that the company sells. For a manufacturing business, COGS includes expenses like materials and labor involved in making the products. In a service-oriented business, the term "Cost of Revenue" is often used instead.

To understand COGS better, consider a furniture company. At the start of the year, the company might have $10 million in furniture inventory. If it spends $2 million adding to this inventory and ends the year with $7 million in inventory, the COGS for that period would be $5 million. This calculation provides insight into what it costs the company to produce or acquire the goods it sells.

For Warren Buffett, analyzing COGS is important to determine the Gross Profit, a critical indicator of a company’s profitability. Gross Profit is essential in assessing whether the company has a sustainable competitive advantage. While COGS alone doesn’t reveal this advantage, it’s an essential part of the bigger picture that Buffett uses to evaluate a company’s financial health and long-term potential.

What is Gross Profit and How Does Warren Buffett Interpret It?

Gross profit is calculated by subtracting the Cost of Goods Sold (COGS) from the total revenue. For example, if a company’s revenue is $10 million and its COGS is $7 million, the gross profit would be $3 million. Gross profit shows how much money a company makes from its products or services after covering the direct costs of production, but before considering other expenses like administration and interest.

The gross profit margin, which is the ratio of gross profit to total revenue, reveals much about a company’s financial health. For Warren Buffett, a high and consistent gross profit margin is often a sign of a "durable competitive advantage" — a company’s ability to outperform its competitors over time. He looks for businesses with high gross profit margins (often 40% or more), as they usually indicate strong pricing power and efficiency. For example, companies like Coca-Cola and Moody's maintain gross profit margins above 60%, demonstrating a competitive edge that Buffett values.

In contrast, companies with lower gross profit margins often face intense competition, which forces them to reduce prices and, consequently, profitability. Industries with highly competitive environments, such as airlines or automotive companies, typically show lower margins.

Buffett also emphasizes the importance of consistency in gross profit margins over the years. This consistency suggests a sustainable advantage, which can protect the company during economic downturns. While a high gross profit margin alone doesn’t guarantee success, it is a strong indicator of a company’s ability to maintain profitability and potentially provide long-term value for investors.

What are Operating Expenses and How Does Warren Buffett Interpret Them?

Operating expenses are the costs a company incurs to keep its business running, and they appear right below the gross profit line on the income statement. These expenses include a range of items such as research and development (R&D), selling costs, administrative costs, and any other costs associated with bringing a product or service to market. They also cover depreciation, amortization, restructuring, and other non-recurring expenses.

When added together, these costs make up the company’s total operating expenses. By subtracting operating expenses from gross profit, we get the operating profit or loss. For Warren Buffett, analyzing operating expenses is essential to understand how efficiently a company is managed. High or rising operating costs without a corresponding increase in revenue can be a warning sign that the company might struggle to maintain profitability.

Buffett examines each type of operating expense to see if the company is investing wisely in areas that will drive long-term growth, like R&D, or if it is overspending in ways that don’t add value. By understanding a company's operating expenses, Buffett can assess whether it is positioned for sustainable growth or if its costs are eating into its potential profitability.

What are Selling, General, and Administrative (SG&A) Expenses and How Does Warren Buffett Interpret Them?

Selling, General, and Administrative (SG&A) expenses include all the indirect costs involved in running a company, such as salaries, advertising, legal fees, and other administrative costs. These expenses are essential to consider because they impact a company’s bottom line and vary significantly from business to business. Companies with a durable competitive advantage, like Coca-Cola, tend to maintain a consistent SG&A percentage relative to their gross profit, reflecting strong cost control. For example, Coca-Cola spends around 59% of its gross profit on SG&A expenses, while Moody’s maintains about 25%.

In contrast, companies without a competitive edge often see wild fluctuations in their SG&A costs, especially during tough times. For instance, GM’s SG&A expenses can reach up to 780% of its gross profit, a sign of instability and excessive spending. If a company struggles to control SG&A costs, it can eat into profits, especially when revenues fall, putting the company in financial distress.

Buffett looks for companies that can keep SG&A expenses consistently low—typically under 30% of gross profit. If a company’s SG&A expenses are close to or over 100%, it’s likely in a highly competitive industry where no one has a lasting advantage. Buffett also avoids companies with low SG&A but high costs in areas like R&D or capital expenditures, which can undermine long-term profitability.

In his analysis, Buffett prefers companies with steady and manageable SG&A expenses, as this consistency is a hallmark of strong management and long-term economic stability. He is cautious with companies burdened by high SG&A, especially when combined with high debt or extensive R&D, as these factors can make it challenging to achieve sustained profitability.

What is Research and Development (R&D) and How Does Warren Buffett Interpret It?

Research and Development (R&D) expenses represent the costs a company incurs to create new products or improve existing ones. For companies that rely heavily on innovation, like pharmaceutical or tech firms, R&D is crucial to maintaining a competitive edge. However, Warren Buffett views high R&D spending with caution. He believes that companies with a durable competitive advantage shouldn’t need to invest heavily in R&D just to stay relevant. If they do, it indicates that their competitive advantage may be short-lived.

Buffett prefers companies like Moody’s and Coca-Cola, which either don’t spend on R&D or have low R&D expenses. These companies have established positions in their markets and don’t rely on constant innovation to keep customers. In contrast, companies like Merck must spend significant amounts on R&D and additional selling and administrative costs to promote their new products. If Merck fails to create the next big product, it risks losing its competitive edge.

For Buffett, companies that depend heavily on R&D are not “sure things” because their future success is tied to ongoing innovation and the risk of obsolescence. His ideal investments are in companies with stable long-term economics that don’t hinge on high R&D spending to maintain their market position. Simply put, if a company’s success relies on continuously outpacing technological advancements, it’s not the type of investment Buffett prefers.

What is Depreciation and How Does Warren Buffett Interpret It?

Depreciation represents the gradual expense of assets like machinery or buildings over time as they wear out. Instead of recording the full cost of an asset in the year it’s purchased, companies spread the cost over its useful life. For example, if a company buys a printing press for $1 million with a lifespan of 10 years, it will record $100,000 in depreciation expense each year. This accounting method helps reflect the true cost of using the asset over time.

Financial analysts on Wall Street often focus on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) because it ignores depreciation, making profits look higher. However, Warren Buffett warns that depreciation is a real expense. Ignoring it can give a false impression of profitability, as eventually, the asset will need to be replaced, which requires actual cash.

Buffett prefers companies with lower depreciation costs as a percentage of gross profit, as it suggests a less capital-intensive business. For instance, companies like Coca-Cola and Wrigley have relatively low depreciation costs, which aligns with their durable competitive advantages. On the other hand, companies in highly competitive industries often have higher depreciation costs, which can eat into profits.

In Buffett’s view, a business that keeps depreciation costs low can retain more profit, enhancing its long-term value and making it a more attractive investment. Depreciation, when managed effectively, contributes to building a more sustainable and profitable business.

What is Interest Expense and How Does Warren Buffett Interpret It?

Interest expense reflects the cost a company pays on its debt. While banks may earn from interest, most manufacturing and retail companies aim to minimize this expense. The more debt a company carries, the higher its interest expense. This is why Warren Buffett looks carefully at interest expenses — they reveal a lot about a company’s financial health and level of debt.

Buffett has observed that companies with a strong, durable competitive advantage usually have little to no interest expense. For example, Procter & Gamble pays only about 8% of its operating income in interest, while Wrigley pays around 7%. In contrast, companies in highly competitive or capital-intensive industries, like Goodyear in the tire industry, might pay as much as 49% of their operating income in interest due to high debt levels.

Buffett also compares interest expenses across industries. In the airline sector, for example, profitable Southwest Airlines pays only 9% of its operating income in interest, while financially troubled United Airlines pays 61%. High interest expenses can be a warning sign, indicating financial strain or poor competitive positioning.

For Buffett, companies with the lowest ratio of interest expense to operating income are usually the strongest investments. These companies are less burdened by debt and more likely to sustain profitability over the long term. In short, Buffett’s rule is simple: in any given industry, the company with the lowest interest expenses relative to its income typically has the most durable competitive advantage.

What is Gain (or Loss) on Sale of Assets and Other, and How Does Warren Buffett Interpret It?

When a company sells an asset, such as property or equipment (excluding inventory), any profit or loss from the sale is recorded under “Gain (or Loss) on Sale of Assets.” This figure represents the difference between the sale price and the asset's book value after depreciation. For example, if a company sells a building for $800,000 that it originally bought for $1 million and depreciated to $500,000, it records a $300,000 gain. Conversely, if the building sells for $400,000, it incurs a $100,000 loss.

The “Other” category includes unusual or infrequent income and expenses, such as gains from licensing agreements or patent sales. These non-operating events don’t happen regularly and can sometimes significantly impact a company’s profits.

Warren Buffett advises removing these nonrecurring items from net earnings when evaluating a company's long-term competitive advantage. Since they are irregular and do not reflect the company’s core business operations, including them could distort the true earning power of the business. For Buffett, a company’s real profitability comes from its primary operations, not from one-time gains or losses.

What is Income Before Tax and How Does Warren Buffett Interpret It?

Income before tax is the profit a company makes after covering all expenses, except for income taxes. It’s a key figure that Warren Buffett uses to assess the return on his investments, whether he’s buying an entire company or a portion of it through stock purchases.

Buffett prefers to analyze investments on a pre-tax basis because it provides a standardized way to compare returns across different investments. For example, when he invested in tax-free bonds from the Washington Public Power Supply System (WPPSS), earning $22.7 million in tax-free interest annually, he calculated that this was equivalent to a pre-tax income of $45 million. He considered this a bargain, as he essentially bought the bonds at a 50% discount compared to similar business investments.

Buffett’s focus on pre-tax income helps him think of certain companies as “equity bonds” with an expanding interest rate, especially those with a durable competitive advantage. By evaluating companies in this way, he can gauge their potential returns more consistently, allowing him to make better investment decisions based on their fundamental earning power.

What is Income Taxes Paid and How Does Warren Buffett Interpret It?

Income taxes paid is the amount of tax a company owes on its pre-tax income, typically around 35% for American corporations. This amount is recorded on the income statement, reflecting the company’s true earnings after taxes.

Warren Buffett finds this line item interesting because it can reveal whether a company is being honest about its profits. Some companies may attempt to present higher earnings by manipulating their tax reporting. To verify, Buffett suggests looking at the company’s pre-tax income and subtracting about 35%. If the resulting figure doesn’t match the income taxes paid, it could be a red flag.

Buffett has learned that companies engaged in misleading tax practices are often not transparent with shareholders either. In contrast, companies with a durable competitive advantage tend to have robust earnings and don’t need to resort to such tactics. For Buffett, the best companies make enough money honestly, without needing to manipulate their tax or earnings reports.

What are Net Earnings and How Does Warren Buffett Interpret It?

Net earnings represent the company’s profit after all expenses, including taxes, have been subtracted from revenue. For Warren Buffett, the focus is on whether net earnings show a consistent upward trend over time. This trend suggests that the company has a durable competitive advantage. He looks beyond short-term fluctuations, aiming instead to identify companies with a reliable and historically upward path in their earnings.

Buffett also considers the impact of share repurchase programs, which can artificially increase per-share earnings by reducing the number of shares. This effect can sometimes make it appear as though earnings are rising, even if total net earnings are flat or declining. Therefore, he examines both per-share and total net earnings to get a true picture of a company’s performance.

Buffett prefers companies with a high percentage of net earnings relative to total revenues. For example, Coca-Cola and Moody’s earn 21% and 31% of their revenue as net income, reflecting their strong competitive positions. In contrast, companies in highly competitive industries, like airlines or automakers, typically report much lower net earnings as a percentage of revenue, signaling tougher economic conditions.

As a general rule, Buffett finds that companies with a net earnings margin over 20% on total revenue often have a competitive advantage, while those consistently under 10% operate in more competitive environments. Financial companies are an exception, as a high net earnings ratio can sometimes indicate higher risk-taking rather than long-term stability. For Buffett, understanding net earnings as a percentage of revenue helps him evaluate the underlying economics of the business and its potential for sustainable growth.

The information is provided for educational purposes only and does not constitute financial advice or recommendation and should not be considered as such. Do your own research.