Buffet on Financial Statements

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Introducing Financial
Accounting for MBAs
         Buffet’s Acquisition Criteria
   Large purchases (at least $50 million of before-tax earnings),
   Demonstrated consistent earning power (future projections
    are of no interest to us, nor are ―turnaround‖ situations),
   Businesses earning good returns on equity while employing
    little or no debt,
   Management in place (we can’t supply it),
   Simple businesses (if there’s lots of technology, we won’t
    understand it),
   An offering price (we don’t want to waste our time or that
    of the seller by talking, even preliminarily, about a
    transaction when price is unknown).

          Financial performance is an important factor
                        in Buffet’s criteria
Buffet’s Concept of “Intrinsic Value”

 Intrinsic value is an all-important concept that
 offers the only logical approach to evaluating the
 relative attractiveness of investments and
 businesses. Intrinsic value can be defined simply:
 It is the discounted value of the cash that can be
 taken out of a business during its remaining life.
        Buffet’s Three Suggestions for
1.   Beware of companies displaying weak accounting. If a
     company still does not expense options, or if its pension
     assumptions are fanciful, watch out. When managements
     take the low road in aspects that are visible, it is likely they
     are following a similar path behind the scenes. There is
     seldom just one cockroach in the kitchen.
2.   Unintelligible footnotes usually indicate untrustworthy
     management. If you can’t understand a footnote or other
     managerial explanation, it’s usually because the CEO
     doesn’t want you to. Enron’s descriptions of certain
     transactions still baffle me.
3.   Be suspicious of companies that trumpet earnings
     projections and growth expectations. Businesses seldom
     operate in a tranquil, no-surprise environment, and
     earnings simply don’t advance smoothly (except, of course,
     in the offering books of investment bankers).
Business Activities
            Planning Activities
   A company exists to implement specific goals
    and objectives.
   A company’s goals and objectives are captured
    in a business plan.
   Information on planning activities is often
    obtained through:
     The Letter to Shareholders
     The Management Discussion and Analysis (MD&A)
                Financing Activities
   A company requires financing to carry out its
    business plans.
   Financing activities refer to methods that
    companies use to raise the funds to pay for
    resources such as land, buildings, and equipment
   There are two main sources of financing:
     Equity financing
     Creditor (or debt) financing
Examples of Company Financing
      Types of Creditor Financing
   Investing creditors—those who primarily
    finance investing activities (such as bank

   Operating creditors—those who primarily
    finance operating activities (such as suppliers).
Breakdown of Creditor Financing
            Investing Activities
   Investing activities are the acquisition and
    disposition of resources (assets) that a company
    uses to produce and sell its products and
   The investing resources, or assets, are of two
     Operating assets—resources devoted to operating
     Nonoperating (financial) assets—resources devoted
      to nonoperating activities
Breakdown of Operating and
     Financial Assets
The Accounting Equation
           Operating Activities
   Operating activities are the use of company
    resources to produce, promote, and sell its
    products and services.
   Operating Revenues (or sales) - the inflow of
    assets from selling products and services.
   Operating Expenses (or costs) - the outflow of
    assets to support operating revenues
   Operating Income = Operating Revenues –
    Operating Expenses
        Defining Company Value
   Most owners and nonowners formalize their
    claims on a company in the form of a contract or a
   Equity securities are common for owners and
    bonds (notes) are common for nonowners.
   These securities are traded in capital markets.
   Value of Company =
    Value of Nonowner Claims + Value of Owner Claims
         The Financial Statements
   Balance Sheet – assets, liabilities and equity at one point in time

   Income Statement – revenues, expenses, and profit over a
    period of time

   Statement of Equity – changes in contributed and earned

   Statement of Cash Flows – net cash inflows (outflows) form
    operating, investing and financing activities
Financial Statements
                 Balance Sheet
   A balance sheet reports on investing and
    financing activities.
   It lists amounts for assets, liabilities, and equity
    as of a point in time.
   The accounting equation (also called the balance
    sheet equation) is the basis of the balance sheet:
               Assets = Liabilities + Equity
Berkshire Hathaway’s Balance Sheet
              Income Statement
   An income statement reports on operating
   It lists amounts for sales (and revenues) less all
    expenses (and costs) over a period of time.
   Sales less expenses yield the ―bottom-line‖ net
    income amount.
Berkshire Hathaway’s
 Income Statement
            Statement of Equity
   The statement of equity reports on changes in
    the accounts that makeup equity
     Contributed capital
     Earned capital (retained earnings and accumulated
      other comprehensive income)
   This statement is useful in identifying and
    analyzing reasons for changes in owners’ claims
    on a company’s assets.
      Berkshire Hathaway’s
Statement of Stockholders’ Equity
             Statement of Cash Flows
   The statement of cash flows reports on cash flows for
    operating, investing, and financing activities over a period
    of time.
      Information Beyond Financial
   Management Discussion and Analysis
   Independent Auditor Report
   Financial Statement Footnotes
   Regulatory Filings and Proxy Statements
Buffet on MD&A
        Economics of Accounting
     Information: Demand & Supply
   Demand for financial accounting information
    extends to numerous users that include:
     Managers and employees
     Creditors and suppliers

     Shareholders and directors

     Customers

     Regulators

     Voters and their representatives
    Supply of Accounting Information
   Determined by a company’s estimates of the
    benefits and costs of disclosure.
   Regulation and bargaining power also play roles
    in determining the supply of financial
    accounting information.
   The SEC requires financial statements, various
    note disclosures, and other reports on a regular
    Supply of Accounting Information
   Benefits of disclosure
       lower capital cost from improved transparency
       reputation effects enhance labor recruiting
   Costs of disclosure
       Information gathering costs
       More information to competitors
       Potential litigation costs
       Potential political costs
Market Efficiency
           Profitability Analysis
   Return on Assets (ROA):
       ROA = Net Income / Average Assets

   For example, if we invest $100 in a savings
    account yielding $3 at year-end, the return on
    assets is 3%.
Disaggregating Return on Assets
Profit Margin, Asset Turnover, and Return on
        Assets for Selected Industries
                Competitive Analysis
   Bargaining Power of Buyers – Buyers with strong bargaining
    power can exact price concessions and demand a higher level of
    service and delayed payment terms
   Bargaining Power of Suppliers – Suppliers with strong
    bargaining power can demand a higher price for their goods and
    early payments.
   Threat of Substitution – When the number of product
    substitutes increases, sellers lose their ability to raise prices
    and/or pass on cost increases to buyers
   Threat of Entry – New entrants to a market increase
    competition. To mitigate that threat, companies expend money
    to erect barriers to entry. These include R&D, advertising,
    management hires with special expertise, and mergers to create
    economies of scale.
Five Forces of Competitive Intensity
Business Context for Financial
         Accounting Principles and
          Governance Structures
   Information in financial statements enables
    company valuation and, by extension, the
    valuation of its debt and equity securities.
   The importance of financial statements means
    that their accuracy is of paramount importance .
   To the extent that financial performance and
    condition are accurately communicated to
    business decision makers, debt and equity
    securities will be more accurately priced.
    Oversight of Financial Accounting
   Oversight of Financial Accounting
       SEC oversees all publicly traded companies
       EDGAR database (www.sec.gov)
   Financial Accounting Standards Board (FASB)
       Generally Accepted Accounting Principles (GAAP)
   Board of Directors
       Audit Committee
   Courts
                    Audit Report
   Financial statements present fairly and in all material respects
    company financial condition.
   Financial statements are prepared in conformity with GAAP
   Financial statements are management’s responsibility. Auditor
    responsibility is to express an opinion on those statements
   Auditing involves a sampling of transactions, not investigation
    of each transaction
   Audit opinion provides reasonable assurance that the statements
    are free of material misstatements
   Auditors review accounting policies used by management and
    estimates used in preparing the statements
                  Sarbanes-Oxley Act
   The SEC requires the CEO and CFO of a company to
    personally sign a statement attesting to the accuracy and
    completeness of the company’s financial statements.
   The statements signed by both the CEO and CFO contain the
    following commitments:
       The CEO and CFO have personally reviewed the annual report
       There are no untrue statements of a material fact or failure to state a
        material fact necessary to make the statements not misleading
       The financial statements fairly present in all material respects the financial
        condition of the company
       All material facts are disclosed to the company’s auditors and Board of
       No changes to the company’s system of internal controls are made unless
        properly communicated
            Financial Accounting:
             not an exact science
   GAAP allows companies choices in preparing
    financial statements (inventories, property, and
   Companies must choose among the alternatives
    that are acceptable under GAAP.
   Financial statements also depend on countless
Financial Accounting in Context
   A company’s financial statements only tell part
    of the story.
   You must continually keep in mind the world in
    which the company operates.
   Financial statement analysis must be conducted
    within the framework of a thorough
    understanding of the broader forces which
    impact company performance.

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