- 1 Competitive analysis: Why have financial knowledge as a Product Manager
- 2 Accounting Intro: Financial Statements
- 3 Key Financial Indicators everyone should know
- 3.1 Liquidity ratios
- 3.2 Financial leverage / financial health ratios
- 3.3 Efficiency
- 3.4 Profitability ratios
- 3.5 Other ratios
- 4 An Example: Comparing apples with apples
- 5 Conclusion
- 6 Useful Links
Competitive analysis: Why have financial knowledge as a Product Manager
Being a Product Manager also means to have some sort of basic understanding of financial knowledge. What will follow is a quick short way anyone can do, without high-studies in Financial Analysis, to quickly gauge a company’s fitness in terms of economics.
It prepares you for the final level as a Product Manager
If you read the 5 levels of a Product Manager, here you will spot the Entrepreneur.
The Entrepreneur is the last level where the Product Manager has P&L (Profit & Loss) responsibility.
Understanding financials will distinguish you from the pack, keep your business strategy afloat and spot warning signs early both in your own company and in the industry you’re activating in.
It helps you position yourself in a competitive market
One of the roles of the Product Manager is to do market competitive analysis.
Studying competition goes into knowing your position in the market and I’ve covered economic moats and positioning in another post here. Apart from marketing and sales analysis, competitive analysis also benchmarks the companies studied by using financial data to compare and gather valuable information on how companies manage their resources.
How can you study your competition?
If we’re discussing public companies, apart from marketing and sales data, you have a wide array of financial documents that are publicly available that tell you exactly what the competition has done to use to position themselves in the market.
Using financial data with your competitive analysis you can tell where the competition stands in regards to:
- Financial leverage / Financial health;
We’re going to cover next exactly what metrics to look out for in the competitors’ financial statements to give us a hint on where they focus their business strategy more. But first, a little accounting intro. For those of you already familiar with the 3 Financial Statements, please feel free to skip this section.
Accounting Intro: Financial Statements
There are 3 types of financial statements and each have their own role and tell a separate story.
The first rule to keep in mind is that they are all tied together. They are linked and support each other, so to have a complete hypothesis ( I will avoid the word story ) is to go through all of them.
The 3 financial statements we’re going to check are:
- Balance sheet aka statement of financial position;
- Income statement aka Profit and Loss statement;
- Statement of Cash Flows.
Without further ado I’m going to briefly cover what these statements show how they look like.
Please feel free to document yourself further into accounting if this subject has picked your interest. I have also linked to a few useful resources in the Useful Links section below.
The Balance sheet
Remember a time you went on a holiday and took a group picture?
Did you ever post that picture on a social network or kept on a cloud storage service?
If you did so, from time to time, the social network or the cloud service app will show you what you’ve been doing for the last 2-3-7 years ago, by highlighting the pictures.
The balance sheet is exactly that, the picture of a company at an exact time.
The balance sheet shows the resources owned by the company ( assets ), how much it owes ( liabilities ) and what is left to the stakeholders after all debt has been paid ( equity or capital ). Analysts use the balance sheet in their competitive analysis to check the firmness of the financial foundation.
The balance sheet is called like that because it is always in balance, meaning:
Assets = Liabilities + Equity OR Equity = Assets – Liabilities
Let’s say that you want to start your own business and need a loan to do just that. If you borrow 100k from the bank, you are going to have Cash 100k (asset) and you owe the bank 100k (liability) and has not generated any profit ( so 0 equity ).
Thus 100k (Assets:Cash) = 100k(Liabilities:Long Term Debt) + 0 (equity)
If you later add 10k out of your own personal money you will have.
Assets = 110k, Liabilities = 100k and Equity = 10k.
Assets and Liabilities are of two types: current and non-current.
Current means in case of assets = quickly converted into cash ( in the same reporting period ), non-current means that they can be converted into cash after the reporting period, so more of long-term usage.
In case of liabilities = current means to be paid in the same reporting period and non-current after the reporting period, so a long-term debt.
Usually the reporting period is 1 year.
Under Assets, Liabilities and Equity, you will find other entries that reflect where specifically the money went (or came from), such as Inventories or Equipment, but we’re just going to briefly touch upon these with examples.
Here is a typical format for a balance sheet:
The Income statement
The Income Statement also known as the Profit and Loss account.
Here you can find revenues and expenses that the company has amassed during a particular period.
If the balance sheet is a snapshot in time of what the company owns and owes, the Income Statement is the total of how much money the company is making or losing for that time period.
If the Analysts use the balance sheet to test the company’s financial foundation, they use the Income statement to actually test for performance by checking margins and such. This is not only used for competitive analysis.
In this section you will find the 3 major types of profits:
- Gross profit;
- Operating profit;
- Net profit.
You will also encounter Revenue or Total Sales or just Sales, keep in mind that the wording might differ, but the overall format stays the same.
Also another interesting expression to keep in mind is that Net profit is often called “the bottom line” because usually you can find it at the bottom of the Income statement.
If you’ve ever encountered acronyms such as: EBT, EBIT, EBITA, EBITDA and NOPAT it’s from this statement that they’re calculated from.
Just as a short interlude, I’m going to briefly expand the acronyms above:
EBT = Earnings Before Taxes
EBIT = Earnings Before Interest and Taxes
EBITA = Earnings Before Interest, Taxes and Amortization
EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization
NOPAT = Net Operating Profit After Tax
You might think of advanced mathematics or how hard it all sounds, but don’t worry, I assure you it isn’t. With just addition and subtraction you can reach a lot of conclusions about where the money came from and where it went.
We will discuss some of these Financial Indicators below.
Here is how a typical Income Statement format looks like:
And here is an example of how an Income Statement looks like:
The Statement of Cash Flows
Imagine that you have your own business and you sell your services or products.
When the service or product is offered, you offer an invoice and based on that invoice you might not receive cash for the product or service immediately.
Now here’s the catch, the Income Statement records everything on an accrual basis, meaning when the transaction has occurred, in this case, the invoice was released, not necessarily when you received the money.
That means that you will see this transaction on the Income Statement as Revenue, but not actually have cash inside the company.
The statement of Cash Flows only considers cash in and cash out. It does not register transactions only what cash comes in and out of the company.
Given this, I would recommend always looking at the Cash Flow statement first.
The Cash Flow statement has three categories:
- Cash flows from Operating activities;
- Cash flows from Investing activities;
- Cash flows from Financing activities.
The cash flows from Operating activities include activities related to sales and day to day business such as: wages, operational overheads, cost of sales and so on.
The cash flows from Investing activities include activities related to investments in the companies assets that allow proper functioning of the business, such as investments in property, plant and equipment and so on.
The cash flows from Financing activities include activities related to purchases of common stock, issuance of common stock under employee plans and other, issuance of long-term debt, payment of long-term debt and so on.
Here’s how a common Cash Flow statement look like:
How the Three Financial Statements fit together
You can view here for a very nice video better explaining this:
Even though each financial statement offers different information and has a different usage, each of them has a link between each other.
- The Balance Sheet (referred for brevity as B.S.) is connected with the Cash Flow (C.F.) statement:
The Cash entry under Assets in the B.S. statement for two years is the same as the Net increase (decrease) in cash from C.F. statement;
- The Balance Sheet is connected with the Income Statement (I.S.):
The Retained Earnings from B.S. statement is tied with the Net Income from the I.S. statement;
- The Cash Flow statement is connected with the Income Statement:
The Net Income from I.S. is tied with the Net Income from the Operating cash flow category in the C.F. statement.
As you can see, there should not be any discrepancy between the 3 financial statements.
The images attached above are only for format purposes only, these differ between standards ( yes, there are accounting standards and are regulated by policy makers, two such standards are: US:GAAP and non-US: IFRS ).
Also these differ from industry to industry by specifics not by format. Again, this is a whole subject on it’s own and several books have been written to cover this, please document yourself responsibly.
Where to find the Financial Statements
I will not go into details but public companies show this information on their website ( as required by regulations ) under: Investors Relations or Investors.
As a general rule of thumb always use at least 5 years worth of data, 10 years is recommended.
We will talk about growth ratios and how to compare several ratios in the Key Financial Indicators section below.
Key Financial Indicators everyone should know
Liquidity means how efficient is a company in turning it’s assets into cash to fund it’s regular day-to-day operations and most importantly to cover it’s short-term debt. Why is this important? Because usually lenders have a strong preference for cash when settling debt.
This has several implications such as:
- How efficient is a company at collecting it’s bills from customers;
- How good a company is in turning their inventory into cash;
- How much money does a company has on hand to pay for it’s day-to-day operations.
Cash Ratio = Cash & Cash Equivalents / Current Liabilities
E.g. if a company has: Cash = 50k, Marketable Securities = 100k and Short-term debt = 100k
Cash Ratio = 150/100 = 1.5, meaning the company can cover it’s debt 150% and still have some cash on hand to pay something else. This is a good case.
Usually a ratio of at least 0.75 is a good sign.
Current Ratio = Current Assets / Current Liabilities
E.g. if a company has: Cash = 50k, Inventory = 25k, Account Receivable = 10k and Short-term debt = 40k
Current Ratio = 50 + 25 + 10 / 40 = 2.1, this is a very good ratio, generally speaking everything that is over 1.5 as a current ratio is a good sign.
Warning: Current Ratio takes into consideration inventories, but if it’s inventory turnover ratio is low (covered below), then most probably the inventory items will not be able to be sold at the value mentioned in the Balance Sheet ( imagine trying to sell old-furniture ).
Note: Account Receivable means money that you need to collect from the customers ( so it is owed to you ).
In order to be more conservative regarding inventories, another popular ratio is the Quick Ratio which doesn’t take into consideration inventories.
Quick Ratio = Current Assets – Inventories / Current Liabilities
E.g. if a company has: Cash = 50k, Inventory = 25k, Account Receivable = 10k and Short-term debt = 40k
Quick Ratio = (50+10) – 25 / 40 = 0.87, this means that without taking into consideration inventories, this company can cover it’s short-term debts in 87%. This is not so good, usually a Quick Ratio of 1 is considered a water-line, everything below means that for every 0.8$ of your current assets you have 1$ current liabilities.
Warning: Have you seen those Account Receivables for both Quick and Current ratios? Well, they look good on paper, but what happens if the customers don’t pay? Always corroborate the Account Receivables with a quick check on something called “allowance for doubtful accounts“.
This can be found just below the Account Receivables entry on the Balance Sheet and if not, in the Annual Report in the footnotes.
Operating Cash Flow Ratio
If the Current Ratio uses it’s Current Assets to cover it’s Current Liabilities, the Operating Cash Flow Ratio uses cash generated from it’s continuing operations to cover it’s Current Liabilities.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
The Operating Cash Flow(OCF) Ratio is reported on the Cash Flow Statement either using the direct method ( each cash outflow and inflow is reported directly, see example in Cash Flow statement ) or by the indirect method ( it is derived from net income ).
The formula for OCF when in the indirect method is: OCF = Operating Income + Depreciation – Taxes + Change in Working Capital
As with other ratios above, anything above 1 is a good sign.
Financial leverage / financial health ratios
Once we’ve figured out how much a company has cash on hand for day to day operations and to cover it’s short-term debts, we can now focus on it’s overall debt. The problem with debt is that it is a fixed cost. When business is bad, the fixed costs of debt push earnings lower.
Debt To Equity
Debt to Equity analyses how much of a dollar from debt the company generates compared to equity.
Debt To Equity = Total Liabilities / Total Shareholders Equity
Just by glancing over our examples above for ACME company, and looking at the Balance Sheet we have:
Debt To Equity = (Current Liabilities 11.205 + Long-Term Liabilities 3.450 = 14.655) / 11.567 = 1.2
This means that ACME company has 1.2$ of debt for 1$ of equity. Anything below 1 is okay, everything above 2 is considered risky.
NOTE: Take into consideration industries such as banking which will always have a high D/E ratio.
Times Interest Earned or Interest Coverage Ratio
This Ratio is self-explanatory, it measures how well a company can cover it’s interests on it’s outstanding debt from it’s earnings. The higher the better.
Times Interest Earned = EBIT / Interest Expense
Where EBIT = Net Income + Interest + Taxes, if we look at our ACME company example from our Income Statement we have:
EBIT = Net Income 87.404 + Interest Expense 4.200 + Income Tax Expense 14.936 = 106.540
Times Interest Earned = 106.540 / 4.200 = 25. So ACME company can cover 25 times it’s interest which is a pretty safe margin.
Before diving into the bread and butter of a company’s profitability that has a major impact into your competitive analysis we will discuss about how efficiently a company can translate it’s assets into profits. These ratios will be used also in the Profitability ratios below.
The frequency for how a company can out their inventory, especially a higher frequency will tend to outperform other companies that are inventory intensive. This is a critical measure in your competitive analysis, for example in the retail industry. The lower the frequency, the higher the holding costs will be.
Inventory Turnover = Sales / Inventory ( for a more concise number, calculate average inventory: Average Inventory = (Beginning Inventory + Ending Inventory) / 2 )
For example, if we use our ACME company, we have the Revenue: 180.000 and we can imagine they had Inventory worth of 25.000.
Inventory Turnover will be = 180.000 / 25.000 = 7.2. This means that ACME company has turned over it’s inventory 7.2 times in a year.
This ratio tells us how much of revenue is generated from each dollar of asset. The same principle applies for Inventory Turnover.
Asset Turnover = Sales / Assets ( for a more concise number, calculate average inventory: Average Assets = (Beginning Assets + Ending Assets) / 2 )
Looking at our ACME company, we will have: Revenue 180.000 / Total Assets 26.222 = 6.86, which means that for every dollar in assets, ACME generated 6.86$ in Sales. It seems ACME is very efficient at translating it’s assets into money.
This is the most crucial part of our competitive analysis process. How much money a company is generating relative to the money invested in the business. In your competitive analysis, you can just imply plug these ratios into a spreadsheet program (rows) and for columns you can enter the companies to get an overview of which company in a specific sector or industry is more performant in generating profits.
Net Profit Margin
Net Profit Margin is just that, what percentage of the total Sales is left over after everything is paid up.
Net Profit Margin = Net Income / Sales
For example ACME has: 87.404 / 180.000 = 0.48, this means that for every 1$ sale, after operational costs, taxes, interest and everything else they pay, they remain with 0.48$ in hand.
Operating Margin tells you exactly how efficient the company is in generating profits from it’s core business.
Operating Margin = EBIT / Sales
ACME Company = 106.540 / 180.000 = 0.59, this means that the core business is responsible of generating 59% of the total revenue. Which is a good ratio, by reducing their Cost of Goods Sold ( Cost of doing business ) and by employing better management of their resources, they can increase this margin.
Whereas Asset Turnover ratio is how much of the total sales the assets represent, ROA measures how much of the net income comes from it’s assets. In your competitive analysis, if a company can post consistently above 6-7% for at least 5 years, it means it may have some competitive advantage over it’s peers.
ROA = Net Margin x Asset Turnover
Having calculated these before we will have: Net Margin 0.48 x Asset Turnover 6.86 = 3.29, meaning that for each dollar in assets, the company generates 3.29$ in net income.
This ratio for ACME is below benchmark, but in itself doesn’t really tells us if it is a clear indication of something wrong, be sure to check exactly what the industry standard is.
ROE (DuPont’s ROE)
Some companies are not sitting on a large stock of assets, so whenever you’re doing a competitive analysis, as part of the process we will need to see exactly what part of the margins is financed by debt, not assets. This is the indicator that helps us the most to see that.
In general look for above 10% over a 5 year minimum in general for non-financial firms and if you spot a company that in general posts above 15-20% ROE in general for a 5 year minimum, then it should be a very hot company in your competitive analysis heat map.
DuPont’s analysis breaks this ratio into financial activities, to see exactly which ones are contributing to this indicator.
We’ve covered Net Margin, Asset Turnover and now we’re going to explain Financial Leverage ( also called Equity Multiplier ):
Financial Leverage = Assets / Equity
Financial Leverage or Equity Multiplier ratio tells us how much of the company’s assets is financed by equity rather than debt. The higher the company’s assets is financed by debt, you guessed it, the higher the risk.
Going further with our ACME example, we will have: Assets 26.222 / Equity 11.567 = 2.2 . This ratio is an exception to the other multipliers, the lower it is, the better. Here we can see that roughly half of ACME assets are financed by Equity the rest is financed by debt. Be sure to check also the industry standard. For Verizon ( March 2016 ) 245billion Assets over 19billion Equity = 12.9, so … it could be worse.
So let’s calculate the ROE for our ACME company:
ROE = Net Margin X Asset Turnover X Financial Leverage = 0.48 x 6.86 x 2.2 = 7.2
So what can we tell from the ROE’s deconstruction:
- The company doesn’t have a high Net Margin, but…;
- The company does a great job at having it’s asset turnover, that means it’s doing a great job at extracting dollars from every asset it has;
- It doesn’t rely heavily on debt for leverage, having more than half of it’s assets sponsored by the firms equity, so it means it can easily pay it’s debt from it’s ongoing operation AND because it’s high asset turnover.
But it also has a warning sign here, for you doing the competitive analysis, that this specific company, can take on more debt to boost it’s Net Margin by investing in it’s business to boost it’s Net Margins, so…it doesn’t fit the radar, but if it consistently closes to a ROE of say 10%, then for surely it should be on your radar.
Next you can make a very interesting competitive analysis by dividing Free Cash Flow by ROE to come to the conclusion of exactly how much REAL money ( not accrual ) a company has on hand by using leverage and asset turnover.
You can also use ROIC ( Return On Invested Capital ) or ROCE ( Return On Capital Employed ) to see exactly how much the return is on the capital that the shareholders put in. The world is yours. I will leave you to further delve into this subject and if the interest is high on this chapter, I may write a separate blog post on how these ratios are used.
An Example: Comparing apples with apples
For our competitive analysis, we’re going to use 3 companies from the same industry and sector, score them, trend them and reach a conclusion.
The chosen industry is: Retail, sector: Super Markets and Hyper Markets and top 3 companies:
- Walmart ( https://stock.walmart.com/investors/financial-information/sec-filings/2021/default.aspx ) choose annual statements 10-k
- Costco ( https://investor.costco.com/static-files/7ef7bed6-c48f-4687-9c82-eb104b4823a5 )
- Target ( https://corporate.target.com/annual-reports/2020/download/pdf?parts=part6 )
Below you will find an example competitive analysis with trends and using a choice from the financial indicators above. All information gathered from their public websites, correlated with data from Yahoo Finance.
The first thing I urge you to look at is that the ROE is correlated with the Financial Leverage, the lower the financial leverage is, the lower the ROE.
Also ROE is correlated with Debt To Equity Ratio, as you can see, the higher the D/E ratio, the higher the ROE ratio is.
In order to prioritize these companies, you will have to assign some weights to particular indicators of interest, depending on your competitive analysis objective, for me given the retail sector, I would prioritize it like this:
- Inventory Turnover
- Financial Leverage
Why? Because all of them have a ROE over 15%, so I would not hold ROE as an eliminating factor, right off the bat, but we can see that in the case of Target, neither is the Net Profit Margin or the Asset Turnover high, but the Financial Leverage beats the other two companies. So Target relies heavily on Debt, which is correlated with the high Debt to Equity ratio.
So for me Target would be less of a concern, because if I were to activate in the retail field, Target would not be a major threat because the Time Interest Earned is also the lowest of the bunch, that means they are struggling to cover their interest and keep pace with the other two.
The next one would be Walmart, with Costco being the leader in terms of competition. Why? Because the Net Profit Margins are the same for Walmart and Costco, but Costco leads in Operating Margins, Asset Turnover and Inventory Turnover.
Also Costco does a very good job at covering it’s interest, being the leader in Time Interest Earned.
So the clear winners are:
Now this financial competitive analysis has to be correlated with other market studies, so that you know exactly what is the secret of Costco’s really nice Inventory Turnover and Asset Turnover.
To sum up, using data from the Financial Statements to supplement your competitive analysis, not only gives you leverage in terms of knowledge, but also:
- It is concise and readily available;
- It is reliable and audited;
- It is unbiased.
You’ve learned where to look and what financial indicators to keep your eyes on. It is important to also understand that there is no single financial indicator that provides you with a single source of truth, you have to couple some together, because businesses usually make compromises in terms of: profits, efficiency, liquidity and financial health.
When a business fails several dimensions at once, let’s say efficiency, liquidity and financial health, you can be sure that profits won’t be sustainable and a new empty space will be left in the market. Space that will be yours for the taken.
Keep in mind when using financial indicators in your competitive analysis always to:
- Use data and trends for at least 5 years;
- Compare companies from within the same industry and sector.
Hope I have been able to offer some valuable information and would really like to know what financial indicators you use in your competitive analysis.
Thank you and please feel free to check out the links below with books and resources I’ve read that helped me.
- Benjamin Graham’s – The Interpretation of Financial Statements: The Classic 1937 Edition
- Benjamin Graham’s – The Intelligent Investor
- Finance & Accounting for Nonfinancial Managers – Steven A. Finkler
- Analysis for Financial Management – Robert C. Higgins
- Five financial indicators to predict a competitor’s business susteinability