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Management discussion and analysis is an essential component of a company's published annual report. The income statement, balance sheet, statement of cash flows and statement of owner's equity provide quantitative information about the company's performance. The management discussion and analysis, on the other hand, gives qualitative information about the management's assessment of company performance and its outlook for the future.
The discussion provided by the management is intended to identify information that potential investors might not glean from simply reading the numbers in the quantitative financial statements. A synopsis of the company's recent history is used to present a setting for the financial results. A summary of recent mergers or acquisitions and how they affected performance is important to gaining an understanding of the company's current position.
The overview of the management discussion and analysis includes information about how economic or government changes have affected or might affect the company. It presents an assessment of how the company earns income and where it operates, if this information is relevant to the discussion. The overall focus of the management discussion is on items that might have a material effect on the company and a fundamental analysis of the company's results of operations.
The management must discuss trends and risks that might affect future performance. An analysis of the potential positive or negative consequences of certain events helps potential investors understand the company's situation. The management discussion and analysis must also disclose any current or possible litigation and how it might have an impact on the company's financial stability. If there is litigation in process, the management's analysis should assess whether it believes there is any merit in the legal actions and the expected outcome of those actions.
Any off-balance sheet arrangements, such as letters of credit or bonds, that have been issued to secure business dealings must be disclosed by the management. It should discuss any derivative instruments, such as hedge contracts, into which the company has entered in an attempt to reduce the potential risk of price fluctuations or exchange rate variations. Contractual obligations are detailed, because they influence how the company conducts business.
The management discussion and analysis looks at the company's level of liquidity, where and how the company accesses capital, its level of profitability, and the likelihood that the rate of growth or earnings will continue. If any material capital repayments are due in the near future, this must be taken into account. The analysis also evaluates any material accounting estimates that are included in the financial statements and explains how variations in these estimates could affect operating results. Of necessity, some numbers used in financial statements are based on estimates, and it is important that the management discloses the degree of certainty associated with the estimates and the impact on the company if the estimates turn out to be in error.
@Logicfest -- that is important, to be sure but I'm not sure if it is the most important part of the report. One of the things that investors learn about companies in a hurry is that one or two factors are critical to the success of the business. For example, operating ratios (the amount of money it takes to make $1 in revenue) are important to trucking companies and churn rates (the number of customers who switch to other providers) are important to cellular phone providers.
That analysis should include those bits of data. An astute investor can learn a lot about a company by looking at just those bits of data.
That statement about how the company makes money and where it operates is always relevant to the discussion. If we have learned anything over the years it is this -- if a company can't tell you how it makes money in a concise statement, it probably doesn't have much of a future.
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