Pharmaceutical companies have been top performers in the healthcare sector in an era of aging populations, rising health care costs, and the ongoing development of new and extremely profitable medicines. Investors seeking to invest in the best pharmaceutical companies are faced with a wide array of publicly traded companies from which to choose. In order to make informed choices, investors need to consider key financial ratios that are most helpful in the analysis and equity evaluation of pharma firms.
Pharmaceutical companies are characterized by high capital expenditures on research and development (R&D) and having to endure a long time span between initial research and finally getting a product to market. Once a pharma product reaches the marketplace, the company needs to determine how high a price the company can command for a drug in order to earn a profitable return on its investment as quickly as possible. Key financial ratios for pharmaceutical companies are those related to R&D costs, the company’s ability to manage high levels of debt and profitability.
Return on Research Capital Ratio
Because R&D expenses are a major cost for pharmaceutical companies, one of the key financial metrics for analyzing pharma companies is a ratio that indicates what kind of financial return a company is realizing from its R&D expenditures. The return on research capital ratio (RORC) is a fundamental measure that reveals the gross profit that a company realizes from each dollar of R&D expenditures. The ratio is calculated by dividing the current year’s gross profit by the previous year’s total R&D expenditures. Examining the RORC gives investors an idea of how well the company is managing to translate the previous year’s R&D expenses into current year revenues.
Once a pharmaceutical company manages to bring a product to market, a key element is how the company is able to manufacture and sell the product. Therefore, it’s also helpful for investors to look at basic profitability ratios, such as operating margin and net margin. Operating margin, the basic measure of revenues minus production costs, indicates how well the company manages costs, and net margin is the bottom line indicator of profit realized after deducting all of a company’s expenses, including taxes and interest.
Liquidity and Debt Coverage Ratios
Because pharmaceutical companies must make large capital expenditures on R&D, they must be able to maintain adequate levels of liquidity and effectively manage their characteristically high levels of debt.
The quick ratio is a financial metric used to measure short-term liquidity. It is calculated as the sum of current assets minus inventories, divided by current liabilities. The quick ratio is a good indicator of a company’s ability to effectively cover its day-to-day operating expenses.
The debt ratio measures the amount of leverage that a company has, and indicates the proportional amount of a company’s assets that are financed through debt. The ratio is calculated as total debt divided by total assets. Successfully managing debt obligations is a major factor in the long-term viability and profitability of any pharmaceutical company.
Return on Equity
The return on equity ratio (ROE) is considered a key ratio in equity evaluation because it addresses a question of prime importance to investors, which is what kind of return that the company is generating in relation to its equity. A company’s ROE is a valuable indicator of both how effectively the organization is utilizing its equity capital and how profitable the company is for equity investors. The importance of ROE in analyzing pharmaceutical companies stems from the basic fact that pharmaceutical companies must expend massive amounts of capital to bring their products to market. Therefore, how efficiently they employ the capital that equity investors provide is indeed a key indicator of the effectiveness of the company’s management and of the company’s ultimate profitability. ROE is calculated by dividing a company’s net income by total shareholders’ equity. Although a higher ROE figure is generally a better ROE figure, investors should exercise caution when a very high ROE is a result of extremely high financial leverage. This is one reason why it’s also important to consider a pharma company’s debt and liquidity situation.