Royalty Pharma (NASDAQ:RPRX) takes some risk with the use of debt

David Iben summed it up well when he said, “Volatility is not a risk we care about. What we care about is avoiding permanent loss of capital.” So it seems that smart investors know that debt – which is usually associated with bankruptcies – is a very important factor when assessing the risk of a company. Royal Pharmaceuticals plc (NASDAQ:RPRX) has a lot of debt. But the real question is whether that debt makes the company a risk.

When is debt a problem?

Debt helps a company until it struggles to pay it back with either fresh capital or free cash flow. If the company can’t meet its legal obligations to pay off debt, shareholders could end up empty-handed. More common (but still costly), however, is that a company must issue shares at bargain prices, permanently diluting shareholders’ interest, just to shore up its balance sheet. However, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we examine debt levels, we first look at both cash and debt levels together.

Check out our latest analysis for Royalty Pharma

How much debt does Royalty Pharma have?

The image below, which you can click on for more details, shows that Royalty Pharma had $7.60 billion in debt as of June 2024, up from $7.13 billion a year ago. On the other hand, the company has $1.80 billion in cash, resulting in net debt of about $5.80 billion.

How healthy is Royalty Pharma’s balance sheet?

Taking a closer look at the most recent balance sheet data, we can see that Royalty Pharma had liabilities of US$275.7m due within 12 months and liabilities of US$7.63b due beyond that. This had US$1.80bn in cash and US$773.7m in receivables due within 12 months. So liabilities exceed the sum of cash and (near-term) receivables by US$5.33bn.

This deficit isn’t too bad, as Royalty Pharma is worth a whopping $16.9 billion and could therefore likely raise enough capital to stabilize its balance sheet if the need arose. Still, it’s worth taking a close look at the company’s ability to repay debt.

To calculate a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). So we look at debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 3.9, Royalty Pharma has a fairly high level of debt. But the high interest coverage of 7.1 suggests that the company can easily service that debt. Unfortunately, Royalty Pharma’s EBIT actually fell 8.8% over the last year. If earnings continue to decline, managing that debt will be as difficult as delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when analyzing debt. But it’s future earnings, more than anything, that will determine whether Royalty Pharma can maintain a healthy balance sheet going forward. So if you want to know what the professionals think, you might find this free report on analyst earnings forecasts interesting.

After all, a company can only pay off its debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is converted into free cash flow. Looking at the last three years, Royalty Pharma recorded free cash flow of 40% of its EBIT, which is weaker than expected. That’s not good when it comes to paying off debt.

Our view

Both Royalty Pharma’s net debt to EBITDA ratio and EBIT growth rate were discouraging. But covering interest expenses with EBIT isn’t that bad. When we consider the above factors together, we believe Royalty Pharma’s debt poses some risks to the company. While this debt boosts return on equity, we don’t really want to see it increase further from here. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside the balance sheet. Case in point: We found 3 warning signs for Royalty Pharma You should be aware.

Ultimately, it’s often better to focus on companies that have no net debt. You can access our special list of such companies (all with a track record of earnings growth). It’s free.

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