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What These Ratios Tell Us About GlaxoSmithKline plc (ADR) (GSK)

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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.

Today, I’m going to take a look at pharmaceutical heavyweight GlaxoSmithKline plc (ADR) (LSE:GSK) (NYSE:GSK), to see how attractive it looks on these two measures.

GlaxoSmithKline plc (ADR) (NYSE:GSK)

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.

GlaxoSmithKline plc (ADR) (LSE:GSK) (NYSE:GSK) has delivered some stunning ROE figures last five years, as this table shows:

GlaxoSmithKline 2008 2009 2010 2011 2012 Average
ROE 52.5% 61.7% 17.3% 62.2% 66% 51.9%

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
average ROE
Pfizer 6.1% 11.1%
AstraZeneca 9.8% 37.5%
GlaxoSmithKline 230.1% 51.9%

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.

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