What These Ratios Tell Us About GlaxoSmithKline plc

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 (LSE: GSK) (NYSE: GSK.US), to see how attractive it looks on these two measures.

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 (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.

GlaxoSmithKline has delivered some stunning ROE figures last five years, as this table shows:

GlaxoSmithKline20082009201020112012Average
ROE52.5%61.7%17.3%62.2%66.0%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 Glaxo's net gearing and ROE alongside those of its peers, Pfizer and AstraZeneca.

CompanyNet gearing5-year
average ROE
Pfizer6.1%11.1%
AstraZeneca9.8%37.5%
GlaxoSmithKline230.1%51.9%

While Glaxo'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.

Glaxo's net debt increased by £5.0bn in 2012, thanks mainly to its £2bn acquisition of Human Genome Sciences, and the £1.9bn 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.

Despite these risks, I still rate Glaxo as a buy: the world's population is getting richer and living longer, and that means that demand for Glaxo's products will continue to grow.

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