In the most recent Berkshire Hathaway shareholder meeting, there was a gem that Warren Buffett dropped:
“I spend more time looking at balance sheets than I do income statements. Wall Street doesn’t pay much attention to balance sheets, but I like to look at balance sheets over an 8- or 10-year period before I even look at the income account, because there are certain things it’s harder to hide or play games with on the balance sheet than with the income statement.”
This is one of those insights that might fly over you when you first hear it, but becomes critically important once you put some thought into it.
Most equity investors focus primarily on the income statement—I’ve certainly been guilty of this myself. When investors talk about growth, they’re typically referring to increases in revenue or profits, completely ignoring the balance sheet. This is ironic because, in the long run, the balance sheet is the ultimate scoreboard for shareholder wealth. It’s akin to assessing an individual’s financial success solely by their income or income growth, without considering their actual net worth—their assets minus liabilities.
Analyzing Balance Sheets
Great businesses generate compound returns for their owners. To do this, they need to generate a lot of free cash relative to the assets they employ and reinvest that cash flow at high rates of return
On a multi-period balance sheet, taking a close look at the assets (excluding cash) and retained earnings line items can help you determine the above. You want to see a business growing its asset base and retained earnings roughly in tandem. This is a good indicator that the business is reinvesting its capital at high rates of return.
However, there are 3 more typical scenarios when looking at a multi-period balance sheet:
Scenario 1 – both assets and retained earnings remained flat or shrank
Either the business isn’t growing, is shrinking and or management is returning capital to equity holders. Capital isn’t being reinvested.
Scenario 2 – assets grew much faster than retained earnings
The business is reinvesting capital at low rates of return or hoping for future earnings. It’s common to see businesses like this financing their growth through issuing equity or debt.
Scenario 3 – assets grew much slower than retained earnings
The core business has strong earnings, but isn’t reinvesting its capital, or management is allocating capital to pay down debt.
I know this is a gross oversimplification, but I still think it’s a helpful framework to assess whether a business is making money and how management is allocating capital. It doesn’t matter whether it’s an asset-light software business or a capex-heavy industrial business; over the long run, every business is a “balance sheet business”. Looking at a multi-period balance sheet can tell you a lot about the business and the wealth it has created for its owners, which can be a great predictor of the wealth it will create for future owners.
There’s also the liabilities side of the equation, which can tell you a lot about management’s approach to risk management – but that’s a topic for another discussion.
