The fourth part of this series deals with the debt/equity ratio, which is another key component of Warren Buffett’s legendary methodology. In fact, it is a component that the man himself treats very carefully when deciding which stocks to invest in. Just like the return on equity in the previous part of this series, it is an equation that is commonly used in finance, however, Buffett is the one who makes the most and greatest use of it.
The elements that comprise the debt/equity ratio are clearly evident and it’s very likely that many people first got acquainted with it in secondary school in a commerce subject. Nevertheless, some confusion may still reign, hence I will give a simple, short explanation. The debt/equity ratio is calculated by dividing total liabilities 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.
In fact, Buffett takes the results of this ratio very seriously and it’s very educational to comprehend the reasons why. Like all investors, he wants a company to only possess a tiny quantity of debt and the reason why is that a tiny quantity of debt indicates that growth in income is being yielded from shareholders’ equity contrary to borrowed money. If a company utilises borrowed money to finance its income, this usually forms a vicious cycle of debt and repayments which is unstable and which is dependent on 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.
Several investors choose to only use long-term debt rather than total liabilities when calculating the ratio. This could be more effective and handy as stocks investing is for the long run not the short run. This doesn’t come from my own personal view, but in fact it’s part of Warren Buffett’s own methodology.
The fifth and final section of this publication will concentrate on one final component of Buffett’s methodology known as profit margins. Coming soon!