The 4th installment of this publication concerns the debt/equity ratio, another major cog of Warren Buffett's classical investing strategy. In reality, it is an element that the master himself deals with very cautiously when it comes to decide which stocks to put money in. Similar to the return on equity in the 3rd installment of this publication, it is an formula that is typically employed in finance, nevertheless, Buffett uses it more effectively that anyone else.
The debt/equity ratio is made up of 2 obvious parts and it's almost certain that everyone has come across the term some time in their lives, whether it be at school or at another educational institutions. However, some people may not be too familiar with the term, which is why I will now explain it. The debt/equity ratio is equal to total liabilities being divided by shareholders' equity.
Both of these are freely available on a company's balance sheet (sometimes called the statement of financial position). Taking these numbers from these reports is known as taking its 'book value'. On the other hand, if the debt and equity of the interested company are traded publicly, you have the option of using the market value instead. In addition, you may also choose to use a mixture of both the book and market value.
The ratio displays the percentage of equity and debt the company is employing to finance its assets, and a higher ratio indicates that debt is principally propping up the company. The major complication with possessing a high ratio (which indicates a high level of debt when compared to equity) is that it tends to make earnings volatile and be the subject of large interest expenses.
This is something that Buffett takes very seriously and it's important to understand the reasons why. Like everyone else, he prefers to see a small amount of debt and the reason why is that small amount of debt means that earnings growth is being generated from shareholders' equity as opposed to borrowed money. If a company is using borrowed money to finance its earnings, this tends to commence a vicious cycle of debt and repayments which is volatile and which is at the mercy of interest rates.
The lesson to digest from Buffett is to focus your efforts on companies that have a low ratio, or at the least a ratio which is low compared with other firms in the same industry. All that's needed from your part is to calculate the ratios for each company, but as I pointed out previously, the necessary information is often available on company reports.
Many investors prefer to use long-term debt rather than the traditional component, total liabilites, when they are calculating the ratio. According to many, this could prove to be more effective and convenient due to the long term nature of stocks investing. Among these people, Buffett is one of them.
The fifth and final section of this publication will concentrate on one final component of Buffett's methodology known as profit margins. Coming soon!
