A company's balance sheet is a critical tool for investors looking in the healthcare sector, where the same product is often developed and distributed by multiple players.

On this episode of Healthcare Industry Focus, Kristine Harjes and Todd Campbell explain how balance sheets can be used to determine which company is a better investment, using real-world examples of Pfizer (NYSE:PFE) and Bristol-Myers Squibb (NYSE:BMY), which both partner on the anti-coagulant drug Eliquis.

Be sure to listen for which aspects of the sheet to focus your research on, what to look for in the numbers, where to find the data, and how to read between the grid lines to see where a company is heading.

A full transcript follows the video.

 

This podcast was recorded on Dec. 8, 2015.

Kristine Harjes: A healthy balance -- this is Industry Focus. It's December 9th, 2015. I'm your host, Kristine Harjes. You are listening to the healthcare episode of Industry Focus. I've got Todd Campbell, one of our Motley Fool healthcare contributors on the line, and wanted to go no further before saying that yesterday was Todd's birthday. Happy birthday, Todd!

Todd Campbell: Thank you very much. I'm a year older, but I feel a year younger, so I've got that going for me.

Harjes: And a year wiser, too. That's how that works, right? So, buckle up, listeners, we are getting into some pretty nitty-gritty financials today. Specifically, we want to talk about the balance sheet. In my mind, you can split drug developers into two categories: those that are a little bit more established, and those that are not as much. So, our conversation today is really going to focus more on some of the more established companies, but that means that a lot of what we're covering today is applicable across all of Big Pharma, and pretty much any company with a good, established portfolio of drugs, that has money coming in, as opposed to some of these tiny biotechs that we talk about where, when we look at them, we really want to focus on things like cash burn. That's a whole different story.

Before we get into any company specifics, what exactly is a balance sheet?

Campbell: A balance sheet -- first of all, let me start by saying, most investors tend to focus on the sexier numbers -- revenue growth, EPS growth, and the balance sheet sometimes gets forgotten. What I think is very important, though, when investors are considering healthcare companies, is to consider the balance sheet as a very easy to look at, simple to use tool for figuring out, is the company financially healthy? Because in any given quarter, you can put up solid revenue growth, or solid EPS growth. And that doesn't necessarily mean that the company is going to be able to pay its bills over the long haul.

So, what the balance sheet does is it shows you how much a company has in assets, it shows you how much a company owes, and then it shows you how much equity shareholders have in that company. So, essentially what you have is three different pieces of the puzzle. You have assets. Assets will always equal liabilities plus equity. But the big takeaway here is that assets are things like cash, property-planned equipment, things that can be liquidated. Liabilities are things that people owe, like long-term debt, borrowings, those type of things.

Harjes: Yeah, and the other good thing that's included on the balance sheet is the distinction between short-term and long-term for a lot of these items. So, you can really get a picture of, does this company owe a lot of money in the next year? Or, does it have a lot of long-term liabilities? And same thing with assets as well. Meanwhile, you can find these companies' balance sheets on the SEC's Edgar website, which a quick Google search will get you to. From there, find the 10-K, 10-Q filings, and you can find the balance sheets in them.

So, we figured it would be helpful to talk about some specific companies, just to get a sense of how you would compare a balance sheet between several different companies. So, the two that we wanted to highlight were Pfizer and Bristol-Myers Squibb, which you'll hear us refer to as Bristol, BMY, easier than saying the whole thing. The common thread between these two companies is that they're partners on a next-generation blood thinner called Eliquis. Eliquis was approved in late 2012, and has had kind of a slow ramp-up, but it's doing really well now. Last quarter alone, there was $466 million in sales for Eliquis.

Campbell: You look at drug that are growing very quickly, it's very hard for blockbuster drugs, billion-dollar drugs, to keep growing fast, because obviously they're being used with more and more patients. But Eliquis is a very interesting drug, because Warfarin has been used as the mainline anti-coagulant for patients for 50 years. And now, Eliquis, which is a factor Xa inhibitor, works very differently, is starting to really eat into that market share. Sales have doubled in the last year. So, you look at it, you say, "Okay, we've got a company where sales are more than doubling on a drug. Which of these two companies -- they split profit on this drug equally -- might be the better investment, if I want to have exposure to this drug?" One of the ways you can help determine that is by looking at the financial health of the company, which we've already established involves checking out the balance sheet.

Harjes: Exactly. With that, let's dig right in. One of the metrics that I like to look at when I'm considering a balance sheet is called the current ratio. The current ratio basically tells you whether or not a company can pay back its short-term liabilities using its short term assets. How exactly is this calculated?

Campbell: This is a quick and dirty, great ratio for investors to look at, just to say, "Okay, if creditors come knocking, how likely is it that the company is going to be able to pay them?" So, it's like a measure of liquidity. It tells you whether or not a company is likely, a year from now or within this year, to remain solvent. If you have a current ratio that is below one, you should be nervous. If you have a current ratio above one, it's OK.

Harjes: Of course, and you can tell that just from looking at the actual calculation of assets / current liabilities, that one is really your benchmark there of, can you meet these obligations with current liquidity?

Campbell: Right. Again, investors don't have to do this calculation on their own, unless they want to. Plenty of websites that are free online will provide this to you under key statistics or some other area of their website.

Harjes: And so, when you look at the two companies we've been talking about, Pfizer has a current ratio of 1.61, which sounds pretty good, it's above one. But then, you look at Bristol, and they are posting 1.81. So, advantage Bristol there.

Campbell: Yeah, advantage to Bristol on this measure. But it is important to note that both of these companies look good on this measure. Again, above one means there's no short-term risk to them being able to handle their obligations. On the other side, because you may run into this as an investor, when you're considering healthcare stocks, if you end up with a current ratio that's too high, that could be a sign that they're having a hard time figuring out what to do with their money. And they're not re-investing that money in something that's going to provide net income growth down the line. So, you almost want to have a Goldilocks kind of current ratio. And I usually define that as between one and three. So, both of these companies are fine, at 1.61-1.62 for Pfizer and 1.81 for Bristol, but we'll give the edge to Bristol on this one.

Harjes: Sounds good. Next ratio that we wanted to talk about is debt to equity. This one basically tells you how much debt is being used to finance your assets relative to your equity.

Campbell: Right. One of the things that's very important to figure out is, where is money coming from, and is that money being used well? Is it helping to grow the company, or not? And one of the things that I like to consider is the debt to equity ratio. There are various ratios that you can look at, debt to assets, etc. I happen to prefer the debt to equity ratio because it's telling me how much of the money is being financed by loans, and how much is being financed by investors. Again, if you have a debt to equity ratio that's above 100%, it makes you wonder a little bit, because you're saying, "Okay, there's a lot of debt on the books here relative to how much money has come from investors, via retained earnings or the stock offering initially." So, in the case of these two companies, what you want to find is, you want to find a debt to equity ratio that is below 100%. Lower is typically better than higher. And again, since both of these are very big companies, you shouldn't fault them for having some debt. Again, somewhere between 0 and 100% is great. And Kristine, would you do the honors and tell us what those number are?

Harjes: I'd love to. Pfizer clocks in at 58.18%, and BMY comes in at 47.69%. So, that's right in that sweet spot that you were talking about. And the advantage, again, goes to Bristol.

Campbell: Yeah. Bristol-Myers edges out Pfizer on this metric, again. So, we now have it edging out Pfizer on the current ratio, and we now have it edging out on the debt to equity ratio. Now, there's another point, another take away is that I want to make. The reason that we're using ratios rather than absolute numbers -- you could look at it and say, "Wow, Pfizer has more total cash on the books than Bristol-Myers." Or, you could say, "Pfizer has more total debt on the books than Bristol-Myers." But you've got to recognize, too, that these two companies are different sizes. So, you got to normalize that, and ratios allow you to do that.

Harjes: Right, Pfizer is almost double the size of Bristol.

Campbell: Yeah. So, you can't just say, Pfizer's got X billions of dollars more on the books than Bristol, and have that really tell you whether or not one is more financially healthy than the other.

Harjes: So, speaking of scale, let's touch on the white elephant here, which is the fact that Pfizer recently announced an acquisition of Allergan. This would be the biggest-ever pharma acquisition. What is that going to do to Pfizer's balance sheet?

Campbell: Not a heck of a lot. But investors need to be aware that it could have an impact. This is mostly the stock deal. Pfizer is going to become Pfizer Plc, it's getting its headquarters overseas to get some tax savings, etc. But there is a provision in there that allows Pfizer investors to get cash instead of shares in the newly created company. So, there could be a balance sheet impact from the deal, if it goes through. That impact could be as much as $12 billion, it could be as little as $6 billion. It really depends on how many people decide they want the cash and don't want to hold the combined company going forward. Because of that, you can argue that Bristol gets another edge, because there's less uncertainty associated with what's going to happen with the balance sheet for Pfizer over the course of the next year, assuming that this deal goes through. 

Harjes: Yeah, I would agree with that. The biggest thing right now is that we are going through a little bit of uncertainty. Whether you're in favor of this deal or not, you can't quite be sure of exactly how that $12 billion will end up affecting Pfizer's finanacials.

Campbell: Right. And one of the other things that I think is really important when you're considering the impact on balance sheets and how to look at the balance sheet, what important takeaways are from the balance sheet, is to evaluate what the trend has been in the different metrics that are displayed in the balance sheet. So, you've got to consider the current ratio is helpful, the debt to equity ratio is helpful, it's important to know what's going on with the business, for example, what's happening with Pfizer and Allergan.

But you also can glean some insight by saying, "Okay, what's going on with the individual pieces or components of the balance sheet? Is cash, for example, growing over time? Is long-term debt, for example, falling over time?" And what that can indicate to you is, OK, you've got a company that is building up its cash, that can be used to reinvest in companies or new products, or that it's paying down its debt, and it's gonna have to pay less out in interest expense, and therefore could deliver more money to net income. Obviously, if you look at the SEC website and you find a balance sheet and look at it, it's a static number. So, you're going to have to find websites that allow for charting of this information. But they're out there. Motley Fool uses YCharts, for example, to pull a lot of this data together, and trend it out.

Harjes: Yeah. You'll find a lot of articles on our website that include these visuals, so you can get a sense of what's happening with the cash position or the debt or any of these trends that you might be interested in digging a little bit deeper into. As Todd mentioned, that's so important, because it gives you more context for the company. One static number can't really paint the whole picture. 

Going even beyond that, about painting the whole picture, one thing I definitely want to mention is that you can't just look at the balance sheet and say, "Oh my gosh, Bristol-Myers, they win here." You do also want to look at the other thing you hear us talk about on the show all the time, like pipeline and key drugs. So, definitely take a holistic approach when you're doing your research.

As always, remember that people on this program could have interest in the stocks they talk about. The Motley Fool could have formal recommendations for or against, so don't buy or sell based solely on a balance sheet, and don't buy or sell based solely on what you hear. Make sure that you're doing your own research.

Moving on from that, one thing that I think is kind of interesting about looking at a balance sheet is, it can give you a pretty good idea of what's on a company's mind, what they're thinking strategically. One example that comes to mind recently is Gilead Sciences (NASDAQ:GILD), who has a mountain of cash, and still took on more debt to make this mountain even bigger. To me, that and also everything the company has said would agree with this, that indicates that Gilead is thinking about making a move soon, maybe a pretty big, splashy acquisition.

Campbell: If Celgene was the story last year as far as making a big acquisition, Gilead Sciences is going to be the story in 2016 for making a big acquisition. You don't go out and tap the markets for $10 billion when you've already got $15 billion on the books, unless you're thinking about doing something relatively big. Now, granted, you're doing it at a time before interest rates rise. You're getting this money cheaply. You can use it for buyback programs, you can use it to sure up dividends, all those other things, as well. But it certainly would say to me that they're out there hunting. And if they're out there hunting, based on what management has said in the past, I would be looking at companies that are between phase two and phase three -- not necessarily with products on the market, but something that could move the needle. Don't know if it's gonna be cancer, if it's gonna be cardiovascular, I don't know. But something along those lines tends to be what they've focused on in the past, and have indicated they focus on again.

Harjes: Yeah, it'll be interesting. That's another reason to keep an eye on this balance sheet. Maybe this could give us some sort of indication just how big the scale of the deal that they're looking at is.

Campbell: Absolutely.

Harjes: So, one last quick example that we wanted to throw out here before we sign off for the day is, MannKind (NASDAQ:MNKD) and their pretty horrible current ratio. Todd, do you want to dig into that?

Campbell: Yeah. I think one of the reasons that it's helpful when we're diving into a balance sheet to show real-time examples of how this could have helped me as an investor. So, you look at it, and you say, "Well, how would the current ratio really have helped me either get into a stock or avoid a stock?" And in the case of MannKind, it would've helped you avoid it, because MannKind's current ratio has been below one all year long. So, despite all of the hope and optimism that perhaps there in inhalable insulin drug would reach critical mass, and help drive the company into the future, the fact that the current ratio was below one, they just didn't have enough assets that, if anything went wrong, they could cover their obligations. And that would have saved a lot of investors a lot of money, just by taking that extra second or two to look up the current ratio in the company and say, "You know what? I'm gonna let this stock prove itself to me before I go in and invest in it."

Harjes: Yeah. At the end of the day, it's easy to tell a story, especially when you're talking about healthcare, and you're talking about drugs that can save people's lives, or at the very least, vastly improve them. And while we would love to say every single innovative drug is going to change the world, this company's going to make billions and billions of dollars, sometimes that's just not the case. I think MannKind is a really good example here of a company that just doesn't have a financial situation that looks very promising.

So, that's about all the time that we have today. Thank you Todd so much for being here, as always. Listeners, I hope you found this helpful. As Todd mentioned earlier, this isn't the most sexy episode we've ever done, but it is super helpful to be able to dig in to a balance sheet. If, as you're sinking your teeth in, you have some questions for us, feel free, as always, to email us at IndustryFocus@fool.com. Thanks so much for listening!

Kristine Harjes owns shares of Gilead Sciences. Todd Campbell owns shares of Celgene and Gilead Sciences. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Celgene, and Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.