Key financial ratios to assess automobile stocks

The automobile sector is a vital component of the Indian economy as it accounts for around 49% of our manufacturing GDP and 7.1% of the national GDP. Due to this, any developments in this sector have a direct impact on the growth of the national economy as a whole and leadingly, growth in the automobile industry is indicative of the overall strength of the economy.

The major business activities of the automobile industry revolve around the manufacturing, designing, and marketing of automotive vehicles or their components. Consequently, this industry is heavily reliant on resources and is also capital intensive with a majority of the expenditures being incurred in the domains of setting up manufacturing facilities, acquiring state-of-the-art machinery and production-line robotics, labour, raw material, and electricity on top of the research and development initiatives required to keep continuously catering to industry and customer demands.

Let us now understand some key financial ratios which are useful to assess investment opportunities in automobile stocks.

Debt to Equity ratio

The debt to equity ratio measures a company's total liabilities against its total shareholder equity and is used to gauge an automobile company's financial leverage and indicates the extent to which a company is financed by debt relative to equity.

A higher debt to equity ratio is indicative of the automobile company being heavily financed using debt to fuel efforts in research and development or setting up new manufacturing facilities. Whereas, companies with a relatively lower debt to equity ratio might be primarily financed using equity.

Higher debt to equity ratios might also be perceived as risky by lenders and investors alike, and lower ratio might signal that the company is not taking sufficient advantage of leverage in order to maximize its growth and business operations.

The debt to equity ratios of 5 leading Indian automobile companies are:

Bajaj Auto: 0.00

Eicher Motors: 0.01

Mahindra & Mahindra: 0.20

Maruti Suzuki: 0.01

Tata Motors: 1.18

Source: ICICIdirect, data as of Mar 2022

Inventory Turnover ratio

The inventory turnover ratio is key to assessing the efficiency of an automobile company in its inventory management abilities. This ratio can be computed by dividing the COGS, or the cost of goods sold by the average inventory levels during a particular period of time. It is a measure of the number of times an automobile company is able to sell and replace its inventory within the selected time period.

Higher levels of inventory turnover ratio are usually preferred for automobile companies as it is reflective of efficiency in managing their product inventories and selling them quickly. On the other hand, lower levels of this ratio is indicative of the company not being able to sell its products quickly, or that it happens to be carrying too much inventory levels.

In the case of automobile companies, it becomes important to remember that multiple factors ranging from the demand of their vehicles, the seasonality of the economy and business conditions, the production schedule followed by the company, and the distribution channels used to make sales have a major impact on the inventory levels, and leadingly, the inventory turnover ratio of these companies.

Bajaj Auto: 18.7

Eicher Motors: 6.81

Mahindra & Mahindra: 4.94

Maruti Suzuki: 22.1

Tata Motors: 5.96

Source: Screener, data as of 15 May 2023

Operating Margin

Operating margin, which is also called the operating profit margin, evaluates an automobile company's profitability, and can be computed by taking the earned revenue minus all the operating expenses, or the EBIT (Earnings before interest and taxes) of the automobile company, and then dividing this difference by the revenue earned by the company.

The operating margin is reflective of the efficiency of automobile companies in converting the revenues obtained by them into profits after considering all the manufacturing costs associated with the production. Typically, companies with higher operating margins indicate that they are relatively more efficient in controlling their production costs and generating profit as compared to their counterparts with lower operating margins.

Additionally, do note that net margin might be impacted by the slab under which the company falls for taxation purposes, as this ratio only takes into account the operating income before taxes.

The operating margin levels for 5 leading Indian automobile companies are:

Bajaj Auto: 22.04%

Eicher Motors: 26.66%

Mahindra & Mahindra: 7.89%

Maruti Suzuki: 10.88%

Tata Motors: 7.77%

Source: ICICIdirect, data as of Mar 2023

Production Utilization rate

The production utilization rate can be defined as the rate at which the automobile company deploys its manufacturing plants, raw material, and other production facilities in order to manufacture vehicles. This rate is usually representative of the proportion of the production capacity available to the company that is being put to produce vehicles productively.

The production utilization rate is a useful metric to analyse the ability of an automobile company to manage and produce its products, with a higher rate pointing towards favourable utilization of resources as compared to a lower rate, which might signal that the company is underutilizing its potential resources and facilities.

You can find these data from the company’s annual reports and management commentary.

Return on Equity (ROE)

Return on equity (ROE) is an important metric that evaluates an automobile company's profitability as compared to its shareholder equity and is computed by dividing the company’s net income by the total shareholder equity. ROE is used to assess how efficient an automobile company is at generating profits from the shareholder money invested in the company as funding.

A high ROE ratio usually signals that the company is able to generate a high return on the equity invested by shareholders. Whereas a lower ROE ratio may indicate that the company is not generating adequate returns.

The ROE ratios for 5 Indian automobile companies are:

Bajaj Auto: 19.35%

Eicher Motors: 15.48%

Mahindra & Mahindra: 13.35%

Maruti Suzuki: 7.14%

Tata Motors: - 8.05%

Source: ICICIdirect, data as of Mar 2022

Conclusion

Due to the capital and resource intensive nature of the automobile industry and the impact of seasonality and economic conditions on the demand of their products, it is advisable to make use of these ratios together to obtain a realistic perception of the company.

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