Are you an emotional investor? Do you chase hot tips? Do you impulsively buy stocks? Well, no worries. I have 3 key financial ratios that can stop you from making any regretful decisions. Billionaire Warren Buffett pays close attention to these 3 ratios when he is analyzing stocks. Let’s talk about them.
1. Debt/Equity Ratio (Solvency Ratio)
Every asset that a company owns is financed either by debt (corporate bonds or loans) or by equity (shareholder’s/owner’s money). This is similar to when you purchase a house. When buying your house (an asset), you put in some of your equity (down payment) and then finance the rest through a bank (mortgage/loan). Furthermore, in order for any company to be financially healthy, it is important that the debt is not out of control. A high debt to equity ratio is considered risky because the company is taking on debt to finance its growth. If debt is too high, then it creates a solvency issue, which indicates concerns about the company’s ability to pay back its debt.
When using debt to equity ratio, you should compare this ratio with other companies in the same industry. In other words, if you are looking at AAPL’s debt to equity ratio, compare it with that of MSFT. Don’t compare AAPL’s D/E ratio with that of TSLA. By comparing companies in the same sector, you will get an idea which company is more leveraged.
Let’s take an actual numerical example. Ford Motor Company (F) has a debt to equity ratio of 2.94 (in 2017). On the other hand, Toyota Motors (TM) has a debt to equity ratio of 0.55 (in 2017). Just by comparing these 2 companies, you can see that Ford is highly leveraged. Every 100 dollars that Ford has in equity, it has a liability of close to 300 dollar. On the other hand, every 100 dollars that Toyota has in equity, it has 55 dollar in liability. With D/E ratio under control, Toyota Motor is financially healthier than Ford. The greater the debt, the riskier the investment. Warren Buffett prefers debt to equity ratio of 0.5 or lower. Buffett believes that debt can disrupt even the best businesses because it limits flexibility and agility.
2. Current Ratio (Liquidity Ratio)
The current ratio measures the liquidity of a company. This ratio compares the current assets (cash, inventory, and any money coming into the company withing 12 months) to current liabilities (payments due within 12 months). Current ratio is expected to be at least 1.0, which means that the company has enough liquid resources to pay off its current liabilities that are due in the next 12 months. Think of current ratio as: does the company have enough oxygen to last for another year?
It is important that you don’t solely focus on this ratio. Companies can borrow more money in order to increase its cash. This increase in cash will make the current asset number bigger. Consequently, the current ratio will look better since your numerator will be bigger. So, make sure you look at the cash flow to pinpoint how the company is generating cash. Is it from sales or debt financed? You can inflate your assets in various ways.
Ford Motor Company (F) has a current ratio of 1.21 (Most Recent Quarter). This does not mean that Ford is a great company with bright future. 1.21 simply implies that Ford has enough resource to pay off its current liabilities with its current assets. Warren Buffett likes current ratios above 1.5.
3. Return on Equity (ROE)
When we invest our money in a stock, we want to measure what the company is doing with our investment. The return on equity ratio gives us an idea in regards to that. Mathematically, ROE is calculated as Net Income (i.e. sales) divided by Shareholder’s Equity (i.e. our money). So, as an investor, you want a high ROE.
After we discussed Debt over Equity in the first bullet point, you might have thought that you want a company to have a lot of equity. Now, if you want a high ROE, you want the equity (denominator) to be small. So, should the equity of a company be large or small? What do you think? You want a company to be financially healthy i.e. the debt to equity ratio is sound when compared to other companies in the same sector. If a company’s debt to equity ratio is too small, it means that the company is not able to allocate its equity appropriately to generate more income. If the company is not able to generate more income, you will notice the ROE suffer. In a way, ROE tells you how good the management/leadership is at allocating your money towards the growth of the company.
Ford Motor Company (F) has an ROE of 19.7% (Trailing Twelve Months), and Toyota Motors (TM) has an ROE of 13.83% (Trailing Twelve Months). Now, don’t quickly conclude that Ford is better than Toyota. We noticed in the first bullet point that Ford had extremely huge debt and little equity. You have to decide are you okay with Ford’s debt before you get impressed by the 19.7% return. Warren Buffett likes ROE above 8% consistently over a period of 10 years.
Hope you learned a little and found this blog post helpful. We talked about the 3 key ratios that can prevent you from investing in a company set for failure. The 3 ratios being: debt/equity ratio, current ratio, and return on equity. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations and general investment ideas are not to be actioned with real money. Contact a professional and certified financial advisor before making any financial decisions.