Warren Buffett has seven key rules for analyzing income statements that help him quickly assess a company’s financial health. Each rule reveals something unique about the company’s efficiency, profitability, or stability.
By applying these 7 rules, you can gain valuable insight into a business’s strengths and long-term potential.
1. Gross Margin > 40%
Buffett’s first rule is to check a company’s gross margin, calculated by dividing gross profit by revenue. He likes to see this number consistently above 40%, signaling strong pricing power.
For example, if a company makes $100,000 in revenue and its cost of goods sold is $50,000, it has a gross margin of 50% ($50,000 / $100,000).
This high margin shows that the company can set prices well above production costs, often because of brand strength or customer loyalty.
2. Selling, General, and Administrative (SG&A) Margin < 30%
The second rule is to evaluate the SG&A margin, which shows how much the company spends on basic operations (excluding production costs). Buffett prefers an SG&A margin under 30%, as it suggests the brand has strong market presence and minimal overhead.
For example, if a company has a gross profit of $200,000 and spends $40,000 on SG&A, its SG&A margin is 20% ($40,000 / $200,000).
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This margin suggests the company is efficient in its operations and doesn’t need excessive spending to drive sales.
3. Research and Development (R&D) Margin < %30
Next, Buffett examines the R&D margin, looking for it to be below 30%, which can indicate a simpler business model.
For example, if a company has a gross profit of $150,000 and spends $15,000 on R&D, it has an R&D margin of 10% ($15,000 / $150,000).
A lower R&D margin implies that the company doesn’t need heavy investment in new technology or product development to maintain its position.
4. Interest Expense Margin < %15
Buffett’s fourth rule is to review the interest expense margin, which shows how much of the company’s income goes toward interest on debt. He prefers this to be below 15% of operating income, indicating low debt reliance.
For example, if a company has an operating income of $80,000 and pays $4,000 in interest, its interest expense margin is 5% ($4,000 / $80,000).
This low margin suggests that the company is not heavily financed by debt, which is a positive sign of financial stability.
5. Income Tax Margin = Approximately 20%
Buffett likes to see a company’s income tax margin around 20%, as this suggests a transparent approach to tax payments.
For example, if a company has pre-tax income of $60,000 and pays $12,000 in taxes, it has an income tax margin of 20% ($12,000 / $60,000).
A reasonable tax margin often means the company operates in a straightforward manner, avoiding aggressive tax avoidance schemes.
6. Net Profit Margin > 20%
Buffett’s sixth rule focuses on net profit margin, which he prefers to see above 20%. This figure reflects the company’s profitability after all expenses.
For example, if a company has $500,000 in revenue and a net income of $125,000, its net profit margin is 25% ($125,000 / $500,000).
A high net profit margin shows that the company can control costs effectively and likely has a competitive edge.
7. Earnings Per Share (EPS) = Growing
Finally, Buffett looks at earnings per share (EPS) to assess whether the company’s profitability is growing. He likes to see a consistently positive and rising EPS, even during challenging economic times.
For instance, if a company has a net income of $900,000 and 100,000 outstanding shares, its EPS is $9 ($900,000 / 100,000).
Steady growth in EPS over time suggests a company that can generate returns for investors through thick and thin.
Conclusion
In conclusion, Buffett’s seven rules offer a quick yet thorough way to analyze a company’s income statement.
By focusing on these key metrics, investors can better understand a company’s profitability, efficiency, and financial health.