A strong relationship duo: The pharmaceutical industry and finance

Gökhan Öztürk - Finance Blog

Historically, the pharmaceutical sector has been a pioneer in financial efficiency. In an environment of aging populations, increasing healthcare costs, and the continuing production of innovative and highly effective drugs, pharmaceutical companies have a significant contribution to and influence on the healthcare sector. Financing these medications also has a vigorous impact on all human beings. Therefore, there is a strong relationship between pharmaceuticals and finance. Pharmaceutical products help people maintain healthy lives; improve their physical and mental health conditions; and enhance their lifestyle quality while they are under treatment and/or the curing stages of an ailment. However, innovative medicines and novel treatments in particular can be very costly for patients who seek the best possible medical options in place.

Nevertheless, it is absolutely vital to make good use of health services, not only for public administrations, but also for pharmaceutical companies; financial sustainability requires the establishment of a balance between the demand for medications, the cost of fulfilling this demand, and the resources available, in other words, prioritization. Otherwise, shortages occur, and the standard of treatment or drug discovery appraisal shows in the red and ultimately, investment appeal diminishes. Unfortunately, due to limited budgets, lack of human and infrastructural capacity, many nations have a difficult time utilizing or creating incremental resources without breaking financial sustainability by causing debt to rise continuously.

The long, costly, and risky nature of the drug discovery process is the most important challenge facing the pharmaceutical industry. A drug must pass through several stages of experimentation, then clinical trials, and a final approval before entering the market, incurring varying costs at each step. This period is called the “preclinical” process, which involves the search for certain compounds, when the new drug development process begins.

Because of this process, pharmaceutical companies are known as high research and development (R&D) capital intensive businesses with a long duration between the initial research stages and the marketing of a product.

R&D expenses are relatively a significant cost for pharmaceutical companies when considering the new product market entry duration and loss of exclusivity period. A ratio that shows a company’s financial return from its R&D expenses is one of the main financial indicators for evaluating the pharmaceutical business. The return on research capital ratio (RORC) is the amount of profit earned for each dollar spent on research and development. The value is measured by dividing the gross profit of the current year by the overall

R&D expenses of the preceding year. So, the research capital ratio gives investors an opinion on how well the company can convert its R&D costs of the previous year into the profits of the current year.

The Lifeblood of the Pharmaceutical Company: Investment

As we all know, investment is the backbone of each and every company and the return on research capital ratio plays an important role in investors’ decisions.

Increased income, a positive cash flow and continues pipeline investments, or contrarily, if there is sufficient financial capacity, allow companies to sustain and grow their businesses through launching new products and services and to remain competitive in the market.

Due to promising and appealing in-house R&D alternatives and early stage outside investment opportunities; pharmaceutical companies need to synchronize their pipeline growth strategy with their financial reality. Any mismatch with finance prosperity or non-targeted investment decisions could lead to financial unsustainability and lead to a high-debt position for the company thus resulting in volatile earnings due to the interest that they bear.  

Therefore, efficient cash flow management, cash from investments are key where many investment alternatives and trade-offs exist, especially in the pharma industry when decisions show positive results in the long term. Pharma companies are mostly facing governmental pressure to reduce the costs of public administrations through price cuts. They are forced to operate with lower margins and profits despite high initial capitalization and period costs on assets discovered by many years of research and development efforts.

Companies aim to have sustainable revenues and at the same time leadership aims to have a long-term growth trajectory that includes the funding of burdens from current investment decisions and funding needs of short-term growth. At this point it is necessary to bridge any shortfalls between cash used for investments like pipeline, clinical trials, R&D, green field/manufacturing site capacity increases, etc.

There are plenty of ways to maximize the return on assets, but overall working capital reflects the difference between a company’s current assets and its current liabilities. It is defined as the cash in and cash out flows of a corporation’s operating activities (from manufacturing costs to eventually collection). In general, innovative pharmaceutical business is a high-risk, capital-intensive business characterized by substantial upfront costs and a long period to see a financial return. Effective working capital management helps to cover cash position gaps of the long and expensive lead time of the cash generation of a new product from R&D to the selling stage, through regulatory approvals.

The world is changing just as well as the healthcare systems; transformations in healthcare systems also impact the regulations, distribution, prices, pricing decisions of payers, and investment and development decisions of the products by pharma companies. So, increasing the focus on better financial and cash management will contribute to minimizing some of these challenges at the corporate level; along with an improvement in profitability of strong financial management will direct excess cash to vital investments for future growth, to have solid marketing budgets for new product launches, and perhaps for mergers and acquisitions. Ultimately, this will result in better margins and sustainable revenues.

As a result, focusing on optimizing working capital management, financial leverage, and funding high return investments and decisions helps pharma companies obtain a sustainable future without any going concern risks.