What are the key financial ratios of pharmaceutical companies?
In an era of aging populations, rising healthcare costs, and the continuous development of new and highly profitable drugs, pharmaceutical companies have always been leaders in the healthcare industry. Investors seeking to invest in the best pharmaceutical company are faced with a large number of listed companies to choose from. In order to make an informed choice, investors need to consider the key financial ratios that are most helpful for the analysis and equity valuation of pharmaceutical companies.
- When evaluating stocks in a particular industry, some key ratios are more informative than others.
- Pharmaceutical companies are characterized by high capital expenditures, such as the amount of money that must be spent on research and development to create new drugs.
- The key financial ratios of pharmaceutical companies are related to R&D costs and the company’s ability to manage high levels of debt and profitability.
Understand key financial ratios and pharmaceutical stocks
Pharmaceutical companies are characterized by high capital expenditures for research and development (R&D) and the long time from initial research to the final product launch on the market. Once the drug enters the market, the company must determine how high the price the company can charge for the drug in order to obtain a profitable return on its investment in the shortest possible time. The key financial ratios of pharmaceutical companies are related to R&D costs and the company’s ability to manage high levels of debt and profitability.
Research the return on capital
Since R&D expenses are the main cost of pharmaceutical companies, one of the key financial indicators for analyzing pharmaceutical companies is a ratio that represents the financial return that the company realizes from its R&D expenditures. Return on Research Capital (RORC) is a basic measure that reveals the gross profit that a company realizes from every dollar of research and development expenditures. This ratio is calculated by dividing the gross profit of the current year by the total R&D expenditure of the previous year. Checking the RORC allows investors to understand the company’s conversion of the previous year’s R&D expenses into current year’s revenue.
Once a pharmaceutical company manages to bring a product to the market, a key factor is how the company manufactures and sells the product. Therefore, it is also helpful for investors to check basic profit ratios, such as operating profit margin and net profit margin. Operating profit margin is the basic measure of revenue minus production costs, indicating the extent of company management costs, while net profit margin is the bottom line indicator of profit achieved after deducting all company expenses (including taxes and interest).
Liquidity and debt coverage ratio
Since pharmaceutical companies must spend large amounts of capital on research and development, they must be able to maintain sufficient levels of liquidity and effectively manage their characteristic high debt levels.
Quick ratio is a financial indicator used to measure short-term liquidity. It is calculated by subtracting inventory from the sum of current assets and dividing by current liabilities. Quick ratio is a good indicator of a company’s ability to effectively pay daily operating expenses.
The debt ratio measures the amount of leverage a company has and indicates the proportion of the company’s assets financed by debt. This ratio is calculated by dividing total debt by total assets. Successfully managing debt is a major factor in the long-term viability and profitability of any pharmaceutical company.
Return on equity
The return on equity (ROE) is considered a key ratio in equity valuation because it solves the most important issue for investors, namely the type of return a company has to its equity. A company’s ROE is an important indicator of how an organization effectively utilizes its equity capital and the company’s profitability to equity investors.
The importance of ROE in analyzing pharmaceutical companies stems from the basic fact that pharmaceutical companies must spend a lot of money to bring their products to the market. Therefore, how they effectively use the funds provided by equity investors is indeed a key indicator to measure the effectiveness of the company’s management and the company’s ultimate profitability.
ROE is calculated by dividing the company’s net income by the total shareholder equity. Although a higher ROE number is usually a better ROE number, investors should exercise caution when the very high ROE is caused by extremely high financial leverage. This is one of the reasons why it is also important to consider the debt and liquidity status of pharmaceutical companies.