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Warren Buffett on Debt 

Warren Buffett does not like debt

Warren Buffett does not like debt and does not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

In 1982, Warren Buffett noted that Berkshire Hathaway preferred to buy companies with little or no debt and has repeated this mantra on many occasions. He adopts the same philosophy for his company, preferring to avoid debt but where necessary going into it on a long-term basis only with fixed rates of interest and to obtain the finance before they need it.

What Warren Buffett says abour debt

Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

‘Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.

'It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.’

Benjamin Graham on Debt

There are various approaches to looking at a company’s debt. Benjamin Graham, in The Interpretation of Financial Statements, defined some important terms:

Current assets - Assets which either are cash or can be readily turned into cash or will be converted into cash fairly rapidly in the normal course of business. Include cash, cash equivalents, receivables due within one year and inventories.

Current liabilities - Recognised claims against the enterprise which are considered to be payable within one year.

Shareholders’ equity - The interest of the stockholders in a company as measured by the capital and surplus.

The current ratio or the liquidity test

Benjamin Graham believed that the current ratio, the ratio of current liabilities to current debt was important in looking at a company’s financial position. In theory, the higher the ratio, the more comfortable, financially, is the company. This has been called the test of liquidity.

Benjamin Graham said this about the current ratio:

‘When a company is in a sound position, the current assets well exceed the current liabilities, indicating that the company will have no difficulty in taking care of its current debts as they mature.’

There are several reservations here:

• A company with too high a ratio may not be using its surplus funds wisely
• Cash businesses, such as supermarkets, generally require a lower ratio than businesses that have protracted periods for customer payments.

Again, Benjamin Graham:

‘What constitutes a satisfactory current ratio varies to some extent with the line of business …'

In industrial companies a current ratio of 2 to 1 has been considered a sort of standard minimum.’ David Hey-Cunningham believes that a reasonable rule of thumb measure is 1.5 to 1.

The formula is:

Current assets
Current liabilities

The Quick Ratio

Benjamin Graham also looked at the Quick Ratio, a similar calculation but excluding inventory. Again, the size of the ratio will depend upon the business: companies with inventories that can readily be converted into cash probably do not need as high a ratio as those with longer-term inventories. But it was important to Benjamin Graham:

‘In every case, however, the situation must be looked into with some care to make sure that the company is really in a comfortable current position.’

The formula is:

Current assets - inventory
Current liability

David Hey-Cunningham writes about the acid test, which uses the same ratio as above, but does not include any bank overdraft in current liabilities.

Debt to equity ratios

This shows the proportion of debt to shareholders’ equity. Debt can be either the total debt or more commonly long-term (interest bearing) debt. David Hey-Cunningham gives the rule of thumb test as 0.5 to 1. The formula is generally quoted as:

Long-term debt
Shareholder’s equity

Warren Buffett and long-term debt

Warren Buffett speaks only generally of his approach to debt. Mary Buffett and David Clark have concluded that he focuses on long-term debt, a conclusion that is supported by his public comments. They believe that his concern lies with the company’s ability to repay its debts, should the need arise, from its profits; the longer the time period, the more vulnerable is the company to external changes and the less predictable are its future earnings.

The formula for such a calculation is:

Number of years to pay out debt = Long term debt
                                                 Current annual profit

Company examples

If we apply this formula to Johnson and Johnson, for example, we find, using Value Line, that for 2002, the long-term debt of the company was $2022 million and the profit for that year was $6610 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in .3 of a year.

If we apply the same formula to McDonald’s Corporation, we find, using Value Line, that for 2002, the long-term debt of that company was $9703 million and the profit for that year was $ 1692 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 5.73 years.

By buffettsecrets.com