Stock must be managed by vigilant leaders
Buffettology proposes that for those of us who don’t have the luxury of visiting the management to gauge how well they would manage the company, an alternative would be to evaluate this factor by looking at how well they manage debt. But I would tend to think that, in any case, visiting the management might sometimes create an unnecessary bias when you are making your investment decision.
Warren Buffett and George Soros both do not actually object to the use of debt for a good purpose like in a situation where a company uses debt to finance the purchase of another strategically good company or invest in assets that would reasonably yield a lot more profits. He however objects if the added debt is used in a way that will produce mediocre results.
The act of lending does stimulates businesses earnings since it enables the business invest in more productive assets that they would have otherwise not been able to invest in. The exception arises where the assets that the business is investing in are not physical but financial ones. In this case, the effect might not necessarily be positive. Debt servicing can really have a depressing effect on a business because the resources that would otherwise been devoted towards future stream of income are drained from the business through interest payments. As the total amount of debt outstanding increases the portion that has to be utilized for debt service increases. It is only net new lending that stimulates a business and total new lending has to keep increasing in order to keep net lending stable until the business encounters limit of size problems and it is something you would not want to get caught up in, hence the need to properly evaluate the debts of a company.
There are various methods designed by analysts to check for the health of the business in terms of debt, but I will highlight two that I think you would help you comfortably get a quick idea on how the business is. The two are Debt to Equity ratio and current ratio.
- Debt to Equity Ratio
As a recap; in the first few lessons, we learnt that Equity is just how much you as the owner would get after selling assets and paying off money owed to lenders in case the business was closed.
The ratio allows us to determine how much debt we get for every shilling we invest in buying a single share.
Ideally when calculating this ratio, we are supposed to get total amount of liabilities, which in the case is what the business owes lenders, over the equity. It is however preferred especially when analyzing a large company to do a ratio of the long-term loans(which are earning interest) against equity.
What is the ideal ratio? In judging whether the debt to equity ratio is too high, it is important to as well put the industry into consideration. For example, manufacturing companies tend to be more capital intensive and therefore you will often find that their debt to equity ratio may be a little high. Also try and look into what the debt is being used for. There are investments that specifically take up debt to just finance projects like in real estate that potentially earn much higher income than the interest paid to lenders. Warren Buffett tends to favor ratios of somewhere around 0.5, because there, the risk is much lower, his preference may however vary with the industry as we had indicated earlier.
You can pick both the equity and debt ratios from the balance sheet.
If the ratio is too high, try and find out what the debt is being used for, if you do not know whether the debt is being used for the right purpose, I think you would be better off steering away from the company and looking for an alternative investment. If you have access to good detailed financial information to gauge all that, then you can take the risk.
- Current Ratio
This is simply used in determining a company’s ability to pay debts that they are supposed to pay in a year or less. It is calculated as a ratio of the current assets against the current liabilities. The two can both be obtained from the balance sheet or consolidated statement of financial position.
Current assets are the cash or other assets that the company is likely to convert into cash within a 1 year period. Current liabilities are the debts that the company will pay within that same year. In doing the comparison, we are able to get a rough idea on whether the company will have to borrow more within the next 12 months to pay off the debts or if it will comfortably pay its short term debts. A ratio of 1.0 means that the business has just enough current assets to cover debts they are supposed to pay within one year. Below 1.0 is bad for the business because it means they will have to borrow more in the next financial year, conversely, above 1.0 is good for the business as it means the business can comfortably cover its current assets.
A ratio of less than one may also signal the probability of more problems arising like issues with suppliers who may not have been paid.
According to the writer of Buffettology, Warren Buffett prefers investing in companies with a current ratio above 1.5; but again, this varies with the industry.
(This post will later be revised to add real company illustration)