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

Auto Industry Overview

The automotive industry consists of a large range of companies that span the globe, such as Ford (F), BMW (BAMXF), and Honda (HMC). The industry includes not only the major auto manufacturers but a variety of firms whose principal business is related to the manufacturing, design, or marketing of automotive parts or vehicles. The United States alone has 16 auto manufacturers that, together, produced almost 11 million vehicles in 2018, the bulk being from the "big three" car manufacturers. The most important part of the industry is the manufacturing and sale of automobiles and light trucks. Commercial vehicles, such as large semi-trucks, are an important secondary part of the industry.

Another essential aspect of the auto industry is the relationship between major auto manufacturers and the original equipment manufacturers (OEM) that supply them with parts, as the major automakers do not actually manufacture the bulk of the parts that go into an automobile. The auto industry is capital-intensive and spends more than $100 billion annually on research and development (R&D).

The automotive industry constitutes one of the most important market sectors. It is one of the largest sectors in terms of revenue and is considered a bellwether of both consumer demand and the health of the overall economy. The industry accounted for nearly 3% of the U.S. GDP in 2018. Analysts and investors rely on a number of key ratios to evaluate automotive companies.

11 million

The number of vehicles the United States produces annually.

Key Financial Ratios

The following are the most important financial ratios that investors and analysts look at when evaluating the auto industry.

Debt-to-Equity Ratio

Because the auto industry is capital-intensive, an important metric for evaluating auto companies is the debt-to-equity ratio (D/E), which measures a company's overall financial health and indicates its ability to meet its financing obligations. An increasing D/E ratio indicates a company is being increasingly financed by creditors rather than by its own equity. Therefore, both investors and potential lenders prefer to see a lower D/E ratio. A D/E ratio of 1 indicates a company whose assets and liabilities are equal. However, it's important to compare D/E ratios to companies within the same industry, as different industries have different debt requirements. The average D/E ratio is typically higher for larger companies and particularly for more capital-intensive industries such as the auto industry. The D/E ratio for the following major automakers is General Motors 1.43, BMW 1.24, Toyota 0.52, and Tata 1.45.

Alternative debt or leverage ratios that are often employed to evaluate companies in the auto industry include the debt-to-capital ratio and the current ratio.

Inventory Turnover Ratio

The inventory turnover ratio is an important evaluation metric specifically applied within the auto industry to auto dealerships. It is usually considered a warning sign for auto sales if auto dealerships begin carrying substantially more than about 60 days worth of inventory on their lots. The inventory turnover ratio calculates the number of times in a year, or another specified time frame, that a company's inventory is sold, or turned over. It is a good measure of how efficiently a company manages ordering and inventory, but more importantly for car dealerships, it is an indication of how rapidly they are selling the existing inventory of cars on their lot.

Alternatives to considering the inventory turnover ratio include examining the days sales of inventory (DSI) ratio or the seasonally adjusted annual rate (SAAR).

Return on Equity Ratio

The ROE is a key financial ratio for evaluating almost any company, and it is certainly considered an important metric for analyzing companies in the auto industry. The ROE is especially important to investors because it measures a company's net profit returned in relation to shareholder equity, essentially how profitable a company is for its investors. Ideally, investors and analysts prefer to see higher returns on equity, and ROEs of 15% to 20% are considered favorable.

Along with the return-on-equity ratio, analysts may also look at the return on capital employed (ROCE) ratio or the return on assets (ROA) ratio.

The Bottom Line

It's important to take a look at many financial ratios to gain an overall idea of how a company is performing rather than just looking at a few in isolation. The three ratios discussed here are important in the auto industry and provide a good indicator of how a company is operating. However, to gain a better understanding of a company, one needs to consider its specific dynamics as well as other ratios to determine its true financial health.