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 understand what a balance sheet is a balance sheet is one of the three major financial statement that shows everything a company owns and owes to others the balance sheet is ruled by the master ACC 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 vers its debt formula here is quite simple you just take the company's cash and cash a equivalence 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 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 that's a positive sign Buffett's rule of thumb number two relates to the company's debt to equity ratio 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 $44,000 we would take that and we would divide it by the company's total equity which in this case is $122,000 that would give us a debt to equity ratio of 0. 33 which is below Buffett's 0.
8 figure now what is this of thumb me 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 in 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 longterm mindset. back/ 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 and 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 stock symbol CMG into finat 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 finat 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 you look at the company's total liabilities they're five 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 sign 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 is5 billion that is actually pulling this number down so if we adjust for the company's long-term leases and its Tre treasury stock the company's debt to equity ratio would actually be far below the 0.
