Is Royalty Pharma (NASDAQ:RPRX) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Royalty Pharma plc (NASDAQ:RPRX) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Royalty Pharma

What Is Royalty Pharma's Net Debt?

As you can see below, Royalty Pharma had US$6.14b of debt at December 2023, down from US$7.12b a year prior. However, it does have US$495.3m in cash offsetting this, leading to net debt of about US$5.64b.

A Look At Royalty Pharma's Liabilities

Zooming in on the latest balance sheet data, we can see that Royalty Pharma had liabilities of US$161.4m due within 12 months and liabilities of US$6.14b due beyond that. Offsetting these obligations, it had cash of US$495.3m as well as receivables valued at US$775.1m due within 12 months. So it has liabilities totalling US$5.03b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Royalty Pharma is worth a massive US$17.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Royalty Pharma has a debt to EBITDA ratio of 3.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 13.0 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that Royalty Pharma's EBIT shot up like bamboo after rain, gaining 62% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Royalty Pharma's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Royalty Pharma's free cash flow amounted to 29% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Royalty Pharma's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Royalty Pharma can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 4 warning signs we've spotted with Royalty Pharma .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.