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

An Auto Industry Overview

The automotive industry consists of a large range of companies that span the globe, such as Ford (F), BMW (XETRA: BMW) 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 13 auto manufacturers that, together, produce almost 10 million vehicles annually. The most important part of the industry is the manufacture and sale of automobiles and light trucks. Commercial vehicles, such as large semi trucks, are an important, but secondary, part of the industry.

An important 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, 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 accounts for nearly 4% of U.S. GDP. Analysts and investors rely on a number of key ratios to evaluate automotive companies.

Debt-to-Equity Ratio

Because the auto industry is capital intensive, an important metric for evaluating auto companies is the debt-to-equity (D/E) ratio 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. In general, an ideal D/E ratio is around 1 when liabilities are roughly equal to equity; however, the average D/E ratio is typically higher for larger companies and for more capital-intensive industries such as the auto industry. The average D/E ratio for major automakers is approximately 2.5.

Alternative debt or leverage ratios 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 other 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 ratio (DSI) or the seasonally adjusted annual rate of sales (SAAR).

Return on Equity

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 12 to 15% 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.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.