Debt to capital
Automobile manufacturing is a highly capital-intensive business. Companies utilize debt extensively in their capital structure. The debt-to-capital ratio calculates the percentage of debt as a measure of total capital-debt and equity.
General Motors’ (GM) debt-to-capital ratio is the lowest among all of the major automakers. Its debt-to-capital ratio is 45.6%. This indicates that General Motors has room to take on more debt without it becoming too much of a burden. General Motors’ net debt is actually negative. This implies that the company has more cash on hand than outstanding debt.
Negative net debt would allow the company to raise more capital in the form of debt and use it for capital expenditure. Ford (F) uses a high amount of financial leverage. Its debt-to-capital ratio is 81.1%. This is significantly above the industry average of 53.1%.
Japanese manufacturers are known for their financial soundness. It’s reflected in their financial structure. Honda (HMC), Toyota (TM), and Nissan are next only to General Motors in the employment of financial leverage. The First Trust NASDAQ Global Auto ETF (CARZ) invests in major automotive companies across the world.
Is leverage good or bad?
Companies need to find the optimal capital structure that minimizes their weighted average cost of capital, or WACC. WACC includes the cost of debt and the cost of equity. Although interest expense reduces the tax that companies end up paying to the government, too much of it may not be a good sign. Companies could have a hard time servicing the debt. Debt also increases investment volatility. Optimal financial leverage increases the return on equity at a higher level of risk. This increases the stock return.
Net debt-to-EBITDA measures the number of years it will take for the company to pay down its debt with current income levels. Luxury brands Daimler and BMW have high net debt-to-EBITDA ratios of 5.24 and 4.03, respectively. A high ratio may limit the company’s ability to raise more debt to invest in capital expenditure.
In the next part of this series, we’ll discuss the major ETFs that you can invest in to get exposure to global automakers.