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 components that make up the debt/equity ratio are fairly obvious and I’m certain that many people first heard of it in high school in a commerce or business class. But just in case, there’s still some confusion, I will give a quick, brief explanation. The debt/equity ratio is given by total liabilities of a company divided by shareholders’ equity.

Both components of the ratio can be easily obtained by accessing a company’s balance sheet, which is also sometimes known as a statement of financial position. This process of finding and taking these numbers is known as taking the ‘book value.’ However, if the debt and equity was being traded publicly, you are able to use the market value if you choose to. Furthermore, you will have the option of using a combination of both.

The ratio illustrates the proportion of debt and equity the company is utilising to support its assets. If a ratio is high, this corresponds to a situation where debt is mainly shoring up the company. The principal dilemma with a high ratio is that it renders earnings volatile and leaves it at the mercy of interest rates, which can be expensive.

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.

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 fifth and final section of this publication will concentrate on one final component of Buffett’s methodology known as profit margins. Coming soon!