18. Warren Buffett's 1st Rule - What is the Current Ratio and the Debt to Equity Ratio Video Lecture | Become an Expert: Value Investing - Business Basics

welcome the course to unit 3 lesson 2
warren buffett's first rule which we're
going to be discussing vigilant
leadership and understanding
debt-to-equity ratio and the current
ratio in this lesson we have for lesson
objectives the first lesson objective is
the defined vigilant leadership the
second lesson objective is to understand
the debt to equity ratio the third
lesson objective is to understand the
current ratio and the fourth lesson
objective is to understand what levels
of debt are acceptable so let's get
started so as you learn in the very
short lesson previous to this one these
are the four rules and the one that
we're going to focus on for this lesson
is a stock must be managed by vigilant
leaders so what does the word vigilant
mean the word vigilant means to be
carefully observant or attentive on the
lookout for possible danger so if you
have a company that's managed by a
person who's vigilant that person is
constantly looking for what could go
wrong with the business and that
person's protecting the business from
those potential dangers so what are the
potential dangers when you're managing
or running a company and as an owner of
a company which you is which would be is
a stockholder the thing you've got to
really watch out for is dead so that's
what we're really going to be talking
about in this lesson as we talked about
Warren Buffett's first rule and we have
two quick tools that we can use at our
disposal for determining a acceptable
level of debt for a company the first
tool that we can use is the debt to
equity ratio and then the second tool we
can use is the current ratio those are
two very important things that you have
to understand whenever you invest so if
this isn't something that you've ever
done before you definitely want to take
notes during this lesson and learn both
these ratios really well so we'll start
off with the first ratio which is the
debt to equity ratio and what we're
going to do is I'm going to go on to MSN
Money and I'm going to pull up two
companies to kind of give you a
comparison of how these two companies
look with their debt to equity ratio and
I'm going to teach you how you can find
the different terminology off the
balance sheet so the two companies that
we're going to use is Disney and Sirius
XM radio so just a quick
overview of what the debt-to-equity
ratio is and I'm going to put this in
terms that are pretty easy for you to
understand if you were to add up all of
your debts right now your credit card
debt your car loan the loan on your home
all of those debts every single one of
them and you added them up let's just
assume that it came to $20,000 because
maybe you're not living at home maybe
you're renting or whatever the case
might be but let's just say that all
your debts come to $20,000 then if you
added up all of your equity okay and the
easiest way to determine your equity is
to to put it in this situation just
assume that you died right now you died
today and whenever you died you're not
married you don't have any kids or
anything like that the money that would
be left in your bank account
if a third person would come in and sell
all the material things in your home
your computer your clothes everything
the value of that would all be added up
okay and then you would you would pay
off whatever debts you had so let's say
your car was worth $20,000 and you had
$10,000 in debt on the car so the net on
that would be $10,000 that would be the
equity all that money that's left after
you add up everything that you have then
you subtract out what you would have
owed whatever's left over is the equity
okay and what you're doing is you're
comparing that debt to the equity and
all you got to do is divide the debts
okay by the equity the equity that's
left over so in that scenario let's just
say that we had $20,000 of debt and that
the equity that would be left after you
would have died would have been $100,000
your debt to equity ratio would have
been point to zero okay Warren Buffett
likes to buy companies that have a debt
to equity ratio that's less than 0.5
zero
so essentially he wants to buy a company
that has for every dollar of equity has
only 50 Cent's of debt as you as that
number becomes higher let's say that the
company would have $1 of debt and one
dollar of equity that ratio would go up
to a 1.0
and that's that's a little higher than
what he likes he likes that
debt-to-equity to be 0.5 or lower if you
don't really understand the term equity
I recommend that you go back to course 1
unit 1 lesson 3 and we discussed that a
little bit more in depth and define that
term maybe a little bit better than what
I did here so let's go ahead and go to
our two companies that I said that we
would assess and look at their debt to
equity which was Disney and the Cirrus
XM radio ok so here I am at MSN comm and
I'm just using msn because I kind of
know where all the terms are at on this
site so I can kind of navigate a little
bit faster for you and what you're going
to do is you're just going to come on
down until you see this area where you
can input a stock quote and so the first
one we're going to look at is Disney and
the ticker for Disney is D is so you'll
go ahead and put that in and just hit
enter and it brings you to all the
information on the Walt Disney Company
ok so what we're trying to find is the
debt to equity ratio and the debt to
equity ratio they have on the very top
page if you just scroll down they have
the debt to equity ratio right here and
you can see that the debt to equity
ratio for Disney is 0.42 if you remember
the rule that Warren Buffett likes to
try company likes to buy companies that
are below a point five zero this company
fits that criteria so it's a point four
- so where is how is that number being
calculated how are they finding that
point four - and how they're doing it is
they're actually pulling that number
from the balance sheet so as you look
over here on the left of the screen you
can see that the balance sheet is under
your three financial sheets which we
learned about in the very first unit of
course one and so we're going to click
on the balance sheet now anytime I look
at a balance sheet I always like to look
at the most recent quarter so in order
to do that you have two options up here
at the top you can see you have annual
and then you have interim and so you're
going to want to look at the interim
because that has the most current
information so you just select that box
which it already is selected for us and
you can see that we're looking at the
second quarter of
2012 and when you look at the balance
sheet it's broken down into two major
groups
you got the assets section and then you
have the liabilities section okay and
then the difference between those two is
the equity which you're going to see
right here so when you take the total
assets which is this number right here
which is that 75 and that numbers and
Millions that's 75 billion dollars in
assets and total assets and you subtract
your total liabilities which is 37
billion dollars when you subtract those
two numbers you get the total equity
which is 38 billion dollars okay so how
they're calculating that debt to equity
ratio is they're coming onto this
balance sheet and they're coming into
the liabilities section which is right
here you got your liability section and
they're looking for anything right here
that has debt so right here we can see
that has debt and the number therefore
is zero then you come over here and you
have another thing that says debt okay
and so that three billion dollars that
you you take that and then you're going
to add this total long-term debt of 12
billion okay and you're going to add up
those terms that have debt attached to
them in the description there when you
add up those terms which in this case is
going to be that 3.4 billion and also
the 12.5 billion you add those two
numbers up and then you're going to
divide that number by the total equity
okay so if we're going to do that real
shorthand just by looking at it real
fast that's you got 3.4 plus which we
can just round up the 3.5 and you had
3.5 plus the 12 point 5 and that's going
to give you your 16 flap you take 16
divided by 38 and that's going to give
you your point 4 and some change that we
saw with the debt to equity ratio so
that's what they're doing and that's how
they're calculating it now is that
something that you actually need to
calculate if you're going to quickly go
through and assess a company probably
not the number that you're seeing on
that top level page is probably pretty
close to what is
so if you do need to come in and figure
it out that's how you would do it though
now there's there's some other ways you
can look at a debt to equity ratio some
people like to come in and they would
like to use the total liabilities they
would actually like to compare all of
the liabilities on here compared to the
equity and in this case you'd see it's
almost a 1.0 because you got 37 billion
compared to 38 billion so that number is
just going to be slightly under a 1.0 so
that's a little bit of a higher estimate
and if you're a more conservative
investor that might be the approach that
you might want to take instead of just
taking the debt terms inside of the
current liabilities and the total
liabilities so just some different
techniques and that's that's totally up
to you how you want to assess your your
valuation and I recommend you know
obviously a more conservative approach
is your beginning and as you get a
little bit more comfortable maybe you
can ease up on how conservative you are
on your approach so for Disney we saw
that the debt to equity ratio was 0.42
which we you know can generally say is a
pretty conservative amount of debt and
Disney should be able to easily pay
those debts at that ratio because they
have enough income coming in in order to
support it so let's go ahead and look at
this Sirius satellite radio in order to
do that we're just going to go up to the
top we're going to type in si RI which
is the ticker for Sirius and we'll go
ahead and bring them up and let's look
at their debt to equity ratio okay so we
just scroll down like we did for a
Disney and we get down to here to the
debt to equity ratio which you can see
it's right here and the debt to equity
ratio for Sirius XM radio is 3.48 now
that number is extremely high and the
easiest way to really understand the
ratio is three dollars and forty eight
cents is debt for every one dollar of
equity in the business and that's how
you got to say it just say whatever the
ratio is and that's always over one
dollar of equity so you can see this
company has a lot of debt right now I'd
argue that there's a whole lot of risk
involved with this
company simply because of the debt alone
if I was looking at investing in this
business I would immediately stop I
wouldn't even go any further in order to
calculate the intrinsic value because it
has way too much debt for me to invest
in it now that might be way too
conservative for your approach but
that's something that you're going to
have to come to terms with and come up
with on your own but for me I like to
look at companies that are well below
the 0.5 there's way too many companies
out on the stock market right now that
have a zero for their debt to equity
because they literally have no debt so
why would I go and buy a company like
this it has a lot of debt has a lot of
risk whenever I can go buy something
else it has absolutely no debt and might
even have better earnings than this
company so that's the debt to equity
ratio so that's the first tool that we
have to assess whether we have vigilant
leaders leading these companies so let's
go back and check out our next tool
which is the current ratio okay like
before we're going to go ahead and use
Disney and Cirrus again to assess the
current ratio so what is the current
ratio what this is is it gives us an
idea how how will the company handle
debt in the next 12 months so when we
were looking at the debt to equity ratio
in the last scenario that was just a
general overview of all the debt added
up and then we were comparing it to the
equity that the company has in this
scenario we're going to look at how much
money the company expects to have coming
in in the next 12 months and how much
they're going to have to pay out and
then in the next 12 months when we look
at that comparison we can then determine
how much debt potentially is this
company going to have to take on if they
have to take on any debt at all so when
we look at the current ratio warren
buffett likes the current ratio above
greater than 1.5 so that's important
you're going to want to write that down
1.5 and above is what you're really
looking for in a current ratio so let's
go ahead and pull up the companies off
of MSN money okay so here we are back at
MSN money with Walt Disney at the top
level page
just follow the same technique as we use
before you type in D is up here in order
to get to the Walt Disney Company and
we're going to go back to the the
balance sheet again in order to
determine the current ratio
unfortunately that current ratio is not
listed anywhere on these top-level pages
this is something that you're going to
have to go to the balance sheet and
assess so I clicked on balance sheet
which was just down on the financials
and when we come to the balance sheet
again you're going to want to put it on
interim and make sure it's there and
when we look at the balance sheet we
have the assets broken down into the two
sections at the top you have the total
current assets and then you have just
total assets when a company lists
something in the total current assets
this means that the company will likely
convert whatever that is into cash
during the next 12 months okay so this
14 billion dollars in total current
assets that's going to be converted to
cash in the next 12 months and that's
going to be a positive that's what's
going to flow into the company so
likewise when you go down into the
liabilities it's broken down into two
sections it's broken down and do your
total current liabilities and then just
total liabilities so total current
liabilities is what they're going to pay
out of the company in the next 12 months
and that is 12 billion dollars which is
lower than the 14 billion dollars that
they have flowing into the company
that's a good thing so when we talk
about the current ratio all we're doing
is we're taking this top number which is
the money flowing in and we're dividing
it by the money flowing out in that
short term that 12 months so if this was
14 billion and this was 14 billion our
current ratio would be a 1.0 meaning all
the money flowing in is exactly the same
money that's flowing out so you're not
going to see a change in your equity
okay that equity which is just the
subtraction of your total assets might
return to the liabilities that's the
difference between this so if this is
equal to this your expectation is that
your equity is not going to change in
the next 12 months now in this scenario
we see that the at the total current
assets
exceed the Total Current Liabilities
that's good so if we want to figure out
the current ratio is we take 14.5
divided by our 12.7 and that's just a
quick way of doing it you would actually
take the full number divided by this
full number so when we take those
numbers and we divide them we get one
point one four okay and if you remember
I said Warren Buffett likes to buy
companies that have a current ratio
above 1.5 so in this case Walt Disney's
current ratio is one point one four and
that's kind of a lower figure it's still
in the positive it's still above the 1.0
which is really your absolute cutoff you
can't be buying companies with current
ratio below a 1.0 so it sits above the
1.0 mark but it's not really as high as
we'd like to see at the 1.5 level yeah
on the stock market right now you can go
out and find companies that have a
current ratio over a 2.0 or a 3.0 what
you're really looking for is a company
that's above 1.5 and maybe around to the
2.0 range that's what you're really
looking for in a current ratio but this
is still acceptable at 1.14 if you
really were interested in buying Walt
Disney and all the other fundamentals
that we're going to talk about in the
following lessons checked out maybe this
is something that you would go ahead and
assume the risk on knowing that it is
pretty close to 1.0 so let's go ahead
and look at the cirrus satellite radio
so we're just going to go up to the top
we're going to type in Si RI and hit
enter and we're going to come on down to
the financial section and we're going to
go ahead and click on the balance sheet
and make sure that you're on interim
okay and so when we look at this number
we see that the number is just 1.3
billion and the liabilities for their
total current liabilities which is the
ones that they're going to have in the
next 12 months is 2.2 billion so when we
take the top number divided by the
bottom number we get a current ratio of
0.5 9 7 which we'll just say is point 6
and that is very bad that is something
that you would want to avoid at all cost
because you know right now that because
that's below the 1.0 based off of that
they're going to have to take on more
debt in the next 12 months because they
don't have a bubble 1.0 so when we're
looking at this current ratio it really
tells us a lot about the financial
health of this company as we look into
the short term in the next twelve months
and for cirrus it's pretty low it's at
point six and that's something that
you're going to want to avoid so I might
have gone a little quick for you um if
that's the case I strongly encourage you
to go back and do a little bit of
research on your own with the debt to
equity ratio and also the current ratio
those are your two tools to understand
how much debt a company has and whether
it's it's at a manageable level or if
it's not an imaginable level and this
all falls under our first rule of Warren
Buffett and that is a stock must be
managed by vigilant leaders so use those
two tools to your advantage and don't
settle for our company that has a lot of
debt so this concludes course to unit 3
lesson 2 where we talked about Warren
Buffett's first rule we talked about the
vigilant leadership the debt to equity
ratio in the current ratio so I'll see
you guys in the next lesson where we
talk about Warren Buffett's second rule