Article Advise

submitted: Jul 30th 2008 | by: MartinSejas | Total views: 1 | Word Count: 517 | |

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 shows the proportion of equity and debt the company is using to finance its assets, and the higher the ratio, the more debt (rather than equity) is financing the company. The main problem with having a high ratio (a high level of debt compared to equity) is that it can result in volatile earnings and 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.

What investors should take from this part of the series is that they should focus on companies that possess a low ratio, but not just any low ratio, it must be low compared to other companies in the same sector. It's not difficult to get the numbers necessary to calculate such a ratio, because as I highlighted in a previous paragraph, this is all available on company reports which themselves are publicly available.

Some investors use only long-term debt instead of total liabilities in the calculation of the ratio. This could prove to be more useful and convenient as investing in stocks is for the long-term not the short-term. This is not just my own personal view, but Warren Buffett's own way of thinking.

The final part of this series will focus on the left over element of Buffett's methodology - profit margins, an underestimated concept in finance today. Keep your eye out for it!

About the Author

Author Martin Sejas is the chief writer of Stocks-And-Commodities.com, an influential stocks trading website dedicated to finding the best and the newest strategies and techniques for stocks and commodities trading. Its mission is to become the 'one-stop shop' on the best stocks trading websites and programs on the Internet.

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