Warren Buffett: How To Analyze An Income Statement (7 Rules)

Warren Buffett has 7 rules of thumb that he uses to analyze an income statement in just a few seconds in this video I'll explain Buffett seven rules and show you how his top holding Apple Stacks up 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 going rule of thumb number one relates to a company's gross margin this is found by taking a company's gross profit and dividing by Revenue Warren Buffett wants this number to consistently be above 40% because it indicates

to him that a company has pricing power here is a sample income statement and what we do is we take the company's gross profit of $112,000 we divide it by the company's revenue of $20,000 and this company has a gross margin of 60% which is well above Warren Buffett's threshold of 40% rule of thumb number two relates to the company's selling General and administrative margin the formula for this rule of thumb is to take a company's spending on selling General administrative and divided by the company's gross profit Warren Buffett wants this number to be under

30% which indicates to him that the product has established itself as a category leader and likely sells itself now the way that companies lay out their income statement changes from business to business some lump them all together under operating expenses others break them out in this case we break out the company's operating expenses we see that sales and marketing spending is $2,000 General administrative spending is $3,000 we add those together and we get $5,000 in total spending on selling General administrative we divide that by the company's gross profit of $112,000 and we get a sgna

margin of 41.6% again Warren Buffett wants this number to be under 30% so this figure would be slightly over Warren Buffett's third income statement rules of thumb relates to a company's research and development margin to find this we take a company's spending on research and development and we divide by gross profit his rule of thumb is that this number is under 30% which indicates to him that the company is a simple business and does not have to spend Bing on research and devel velopment in order to successfully grow if a company breaks out its research

and development spending it would be located in the operating expense portion of an income statement here this company spends $1,000 on research and development we divide that figure by $122,000 in gross profit and we get a research and development margin of 8.3% which is well under Warren Buffett's threshold of 30% income statement rule of thumb number four relates to a company's interest expense margin to find this number we take the company's total interest expense and we now divide it by operating income Buffett likes to see this number be well under 15% which indicate that the

company does not have a lot of debt and is likely to be financed with Equity instead of debt on this income statement we see that this business spent $1,000 on interest expense we divide that by the company's operating income of $5,000 that gives us a interest expense margin of 20% which in this case is slightly above his rule of thumb of 15% income statement rule of thumb number five relates to a company's income tax margin to find this we take the company's total expenses on income taxes and we divide it by the company's pre-tax income

Buffett's rule of thumb here is that figure approximately equals 20% Which is the current tax rate in the United States of America why would Warren Buffett want this number to be 20% well that indicates to him that the company is not actively trying to deceive the authorities and that indicates to him that the management team won't actively try and deceive investors for this company here we see that this business spent 1,00 000 on income taxes we divide that by the company's pre-tax income of $4,000 that gives us an income tax margin of about 25% which

indicates this business is not trying to deceive authorities income statement rule of th number six relates to a company's profit margin now to calculate this we take the company's net income and we divide it by Revenue if a company consistently exceeds a 20% profit margin that indicates that the company likely has a strong competitive Advantage AKA aote working in its favor for this business we take the company's net income of $3,000 we divide it by a revenue of $20,000 and we see the net margin of 15% which is ever so slightly below Buffett's rule of

thumb of 20% Buffett's final income statement rule of thumb relates to a company's earnings per share to figure this out we take a company's net income and we divide it by shares outstanding Buffett's rule of thumb here is that this number is consistently positive and consistently growing especially during periods of economic stress such as 2020 2008 or 2,000 to figure this number out for this business we take the company's net income of $33,000 we divide it by 10,000 shares outstanding and that gives us earnings per share of 30 now we would want to track this

figure over multiple years to ensure that this figure was positive and growing now if you're just in a simple PDF download that has all of Warren Buffett's financial statement rules of thumb on them just visit the website longterm mindset. c/b buffit or click the link in the video description and you'll get a free download now that we know Buffett's income statement rule is a thumb let's take the look at a real income statement to see these rules of thumb in action for this we're going to measure waren Buffett's top holding as of the time is

recording which is Apple Corporation so here are Warren Buffett's rules of thumb let's first start by checking out Apple's gross margin to do so I'm going to go over to finat and load in Apple's ticker symbol which is AAP I'm going to scroll down to the ratios button and then I'm going to click on margins and then I'm going to fire up gross profit margin now Warren Buffett's rule of thumb here is that this number consist recently exceeds 40% now for many years Apple was pretty close to this number but its gross margin was in

the high 30s however after the year 2021 Apple has consistently gotten this number over 40% and it's stayed there ever since so for rule of thumb number one apple gets a passing grade moving on to rule of thumb number two a company's selling General and administrative margin remember that Buffett wants to see this number be under 30% now if we head it over to finat and we pull up the company's gross profit and the Cal spending on selling General administrative we can see that over the last 12 months Apple spent $25 billion on selling General

administrative but the company generated 173 billion in total gross profit if we do that math we see that this company's sgna margin is close to about 12% or so and if we look back historically we also see that this ratio roughly holds true so when looking at Apple's sgna margin we would also give it a passing grade next we're going to check out the company's research and development margin we take the company's spending on R&D divided by a gross profit and we want this number to be under 30% in fin chat if we scroll down

and we pull up the company's R&D expenses we see that over the trailing 12 months this company has spent $30 billion on research and development that is only about 15% or so of the 174 billion in gross profit that the company generate over the same time period moreover if you do that same math looking backwards over time you see that the company has consistently spent well under 30% of its gross profit on R&D so yet again Apple would get a passing grade here moving on to income statement rule of thumb number four the company's interest

expense margin we want to see that interest expense takes up less than 15% of operating income here we are in finat if we scroll down to the company's income statement and we look at the company's operating income we see that this company generated 118 billion in operating income over the last 12 months if we take a look at the company's interest expense in total we see that the company spent about $4 billion on total interest moreover it's generated about $3.8 billion in interest income so the net amount that Apple has spent on interest over the

last 12 months has only about $200 million ion that is well below 15% of the company's operating income so on this rule of thumb Apple certainly gets a passing grade moving on to the company's income tax margin remember we want have to see this figure around 20% or whatever the current tax rate is in the United States of America on fin chat if we scroll down and we're looking at the company's earnings before taxes we see that Apple generated about 118 billion in earnings before taxes and over the last 12 months it spent about $18

billion on interest income if you do that math that gives Apple an effective tax rate of about 15% now while that's below Warren Buffett's general rule of thumb it's important to remember that Apple generates profits in many different countries most of which have a lower tax rate than United States of America for that reason I think it's fair that Apple should get a passing grade on this metric next we're going to take a look at the company's profit margin we take company's net income and we divide it by Revenue now thankfully this is math that

finat will actually do for us if we scroll down to the ratios click on margins and we call up the company's net profit margin we can see that Apple over the last 10 years has generated a net profit margin that is well over 20% in fact over the last 12 months the company has generate a profit margin of more than 26% that indicates that apple is doing something that gives it a competitive Advantage which would give us a green check mark on this rule of thumb as well final number he look at here is the

company's earnings per share we want to see that the company's net income divided by shares outstanding is a positive number that consistently grows heading on over to Finchat and scrolling down we get the company's earnings per share or EPs and if we map this number we'll note that it consistently moves up and to the right even during periods of economic stress such as 2020 for that reason I think we should give Apple a passing grade on this metric too so given that Apple essentially aced Warren Buffett's income statement rules of thumb it's no surprise that

not only is he a shareholder but he is taking a massive position in apple through Berkshire half I hope this video was useful if so give it the thumbs up and let me know in the comment section below what other Financial videos you'd like me to make now if you like this video there's a really good chance you're going to like this other video I made so you should watch it next