With interest rates being at historic lows, it is all too tempting for companies to increase their levels of debt. Simply put, it’s cheaper to borrow at the moment than at any other time in living memory — especially if you’re a major global company.
However, while increased debt can be a good thing due to the improved returns that it offers to shareholders, it inevitably comes with higher risk — particularly when interest rates begin to rise. In other words, higher profits in the short run can come at the risk of not being able to service the debt (via interest payments) or eventually pay it back, leading to financial ruin for the company and, potentially, for investors.
So, with this in mind, is GlaxoSmithKline (LON: GSK) (NYSE: GSK.US) dependent on debt?
While GlaxoSmithKline’s debt to equity ratio currently stands at an extremely high level of 233% (which means that for every £1 of equity, GlaxoSmithKline currently has £2.33 of debt), the company’s high level of profitability means that debt levels are well-serviced.
For instance, the company’s interest coverage ratio is currently 10, which means that interest payments on debt could have been paid ten times by operating profit in 2013. As such, GlaxoSmithKline appears to have sufficient headroom with which to make interest payments at the moment.
Assuming interest payments were to double (as a result of interest rates increasing over the next few years), GlaxoSmithKline should still be able to service its debt — provided profitability remains relatively strong.
On this front the company is making encouraging progress, with its pipeline showing strength and it restructuring away from consumer goods brands such as Lucozade and Ribena towards an even greater focus on research and development.
This move should further improve the pipeline over the medium to long term and, while GlaxoSmithKline is not immune to the ‘patent cliff’ that many Pharmaceutical stocks are currently experiencing (with patents set to expire on some of its key, blockbuster drugs in the next couple of years) it does seem to have the potential to replace them.
As such, GlaxoSmithKline has encouraging prospects for future earnings growth, which should enable it to pay its debt, maintain its relatively generous payments to shareholders and grow the business further. Therefore, GlaxoSmithKline does not appear to be dependent on debt and, moreover, could be a strong performer in 2014.
