Analyze the key financial ratios of the automotive industry

Some of the most critical financial ratios that investors and market analysts use to evaluate companies in the automotive industry include debt-to-equity (D/E) ratios, inventory turnover ratios, and return on equity (ROE) ratios.

Automotive industry overview

The automotive industry is made up of many companies all over the world, such as Ford (F), BMW (BAMXF) and Honda (HMC). This industry includes not only major automakers, but also various companies whose main business is related to the manufacture, design, or marketing of auto parts or vehicles. There are 16 automakers in the United States alone, and nearly 11 million vehicles were produced in 2018, most of which came from the “big three” automakers. The most important part of the industry is the manufacture and sale of cars and light trucks. Commercial vehicles such as large semi-trailer trucks are an important secondary part of the industry.

Another important aspect of the automotive industry is the relationship between major car manufacturers and the original equipment manufacturers (OEMs) that provide them with parts, because major car manufacturers do not actually manufacture most of the parts used in cars. The automotive industry is a capital-intensive industry, spending more than US$100 billion on research and development (R&D) each year.

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The automotive industry is one of the most important market sectors. In terms of revenue, it is one of the largest industries and is considered a weather vane for consumer demand and overall economic health. This industry accounted for nearly 3% of the US GDP in 2018. Analysts and investors rely on a number of key ratios to evaluate car companies.

11 million

The number of cars produced in the United States each year.

Key financial ratio

The following are the most important financial ratios for investors and analysts when evaluating the automotive industry.

Debt to equity ratio

Since the automobile industry is a capital-intensive industry, an important indicator for evaluating an automobile company is the debt-to-equity ratio (D/E), which measures the company’s overall financial status and indicates its ability to fulfill its financing obligations. The increase in the D/E ratio indicates that companies are increasingly financed by creditors rather than their own equity. Therefore, both investors and potential lenders want to see a lower D/E ratio. An AD/E ratio of 1 means a company with equal assets and liabilities. However, it is important to compare the D/E ratio with companies in the same industry because different industries have different debt requirements. The average D/E ratio of large companies is usually higher, especially in capital-intensive industries such as the automotive industry. The D/E ratios of the following major automakers are GM 1.43, BMW 1.24, Toyota 0.52 and Tata 1.45.

The alternative debt or leverage ratios commonly used to evaluate companies in the automotive industry include debt-to-capital ratios and current ratios.

Inventory turnover rate

Inventory turnover rate is an important evaluation index, which is specially applied to auto dealers in the auto industry. If car dealers start carrying more than 60 days of inventory in their batches, this is usually seen as a warning sign for car sales. Inventory turnover rate calculates the number of times a company’s inventory is sold or turned over within a year or other specified time frame. This is a good indicator of how efficiently a company manages ordering and inventory, but more importantly for car dealers, it shows how quickly they can sell their existing car inventory.

Alternative ways to consider inventory turnover rate include checking inventory sales days (DSI) ratio or seasonally adjusted annual rate (SAAR).

Return on equity

ROE is a key financial ratio that evaluates almost all companies, and of course it is also considered an important indicator for analyzing companies in the automotive industry. ROE is particularly important for investors, because it measures the company’s net profit return relative to shareholders’ equity, mainly the company’s profitability to its investors. Ideally, investors and analysts would prefer to see a higher return on equity, and a ROE of 15% to 20% is considered favorable.

In addition to return on equity, analysts may also look at the return on capital used (ROCE) or return on assets (ROA) ratio.

Bottom line

It is important to look at many financial ratios to get a complete picture of the company’s performance, not just look at some in isolation. The three ratios discussed here are important in the automotive industry and provide a good indicator of how companies operate. However, in order to better understand a company, one needs to consider its specific dynamics and other ratios to determine its true financial status.

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