LONDON — Before I decide whether to buy a company’s shares, I always like to look at two core financial ratios — return on equity and net gearing.
These two ratios provide an indication of how successful a company is at generating profits using shareholders’ funds and debt, and they have a strong influence on dividend payments and share price growth.
Return on equity
The return a company generates on its shareholders’ funds is known as return on equity, or ROE. Return on equity can be calculated by dividing a company’s annual earnings by its equity (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.
These figures appear very impressive, but there is a sting in the tail, as I’ll explain in a moment.
What about debt?
A key weakness of ROE is that it doesn’t show how much debt a company is using to boost its returns. My preferred way of measuring a company’s debt is by looking at its net gearing — the ratio of net debt to equity.
In the table below, I’ve listed GlaxoSmithKline plc (ADR) (LSE:GSK) (NYSE:GSK)’s net gearing and ROE alongside those of its peers, Pfizer Inc. (NYSE:PFE) and AstraZeneca plc (ADR) (NYSE:AZN) (LSE:AZN).
|Company||Net gearing||5-year |
While GlaxoSmithKline plc (ADR) (LSE:GSK) (NYSE:GSK)’s ROE is higher than both of its peers, there’s no doubt that based on ROE and net gearing alone, AstraZeneca looks far more appealing then debt-laden Glaxo.
GlaxoSmithKline plc (ADR) (LSE:GSK) (NYSE:GSK)’s net debt increased by 5 billion pounds in 2012, thanks mainly to its 2 billion pound acquisition of Human Genome Sciences, and the 1.9 billion pounds it paid the U.S. government to settle various U.S. federal government investigations.
Is GlaxoSmithKline a buy?
Glaxo is currently in the middle of a program to cut costs, focus investment on products with high growth potential, and dispose of certain non-core or mature products.
As a shareholder, I’m cautiously optimistic that this strategy will result in improved cash generation and debt reduction over the next few years. Without this, Glaxo’s 4.8% prospective yield could become harder for the firm to afford.