We Think Royalty Pharma (NASDAQ:RPRX) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Royalty Pharma plc (NASDAQ:RPRX) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Royalty Pharma

How Much Debt Does Royalty Pharma Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Royalty Pharma had debt of US$7.61b, up from US$6.13b in one year. However, because it has a cash reserve of US$998.6m, its net debt is less, at about US$6.61b.

How Healthy Is Royalty Pharma's Balance Sheet?

According to the last reported balance sheet, Royalty Pharma had liabilities of US$1.17b due within 12 months, and liabilities of US$6.62b due beyond 12 months. On the other hand, it had cash of US$998.6m and US$790.7m worth of receivables due within a year. So its liabilities total US$5.99b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Royalty Pharma is worth a massive US$15.5b, 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 4.4 Royalty Pharma has a fairly noticeable amount of debt. On the plus side, its EBIT was 9.5 times its interest expense, and its net debt to EBITDA, was quite high, at 4.4. It is well worth noting that Royalty Pharma's EBIT shot up like bamboo after rain, gaining 52% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Royalty Pharma can strengthen its balance sheet over time. 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. Looking at the most recent three years, Royalty Pharma recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Royalty Pharma's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, net debt to EBITDA gives us cold feet. Considering this range of data points, we think Royalty Pharma is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Royalty Pharma that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.