Management discussion and analysis

In simple terms

The management discussion and analysis (MD&A) is the part of the annual report where management explains, in words, how the year went and what it expects next. It is useful because management knows the business far better than any outsider. It also needs care, because management chooses what to emphasise and how to describe it.

The best way to read it is as a set of claims to be checked, after you have looked at the statements.

What it must cover

SEBI's rules for listed companies set out what the MD&A should discuss, within the limits of the company's competitive position. The topics include:

• industry structure and developments;
• opportunities and threats;
• segment-wise or product-wise performance;
• outlook;
• risks and concerns;
• internal control systems and their adequacy;
• financial performance in relation to operational performance;
• developments in human resources and industrial relations, including the number of people employed.

If the financial statements depart from an accounting standard, the company must say so and explain why.

Facts, explanations and hopes

Most MD&A sentences fall into one of three kinds:

The skill is noticing which kind you are reading. Explanations and hopes are often written in the same confident tone as facts.

Checking an explanation

Other checks that take a few minutes:

• Margins: if the MD&A credits "operational efficiency", did operating margin actually rise, or did a fall in raw material prices do the work? The margins lesson shows how to tell.
• Segments: does the segment note support the story about which business is growing?
• Cash: does the cash flow statement show the "strong performance" turning into cash?

Outlook and track record

Outlook statements are management's hopes and plans, not promises. The most useful test is history: put three or four years of MD&As side by side and compare what management said it expected with what then happened. A management team whose outlooks prove roughly right deserves more weight than one that is always optimistic and always explains the shortfall.

The risk section

Risk sections are often long, generic and almost unchanged from year to year, listing competition, regulation and the economy in every report. They become useful when they are specific: a named customer that provides a large share of revenue, a licence that expires, a raw material from a single supplier. A new, specific risk that appears suddenly is worth investigating.

Why it matters

The MD&A is the best source for understanding management's view of the business: its industry, strategy and challenges. Reading it critically also tells you something about management itself, whether it explains bad news plainly or buries it, and whether its words have matched its results over time.

Limitations

• The MD&A is written by the company. Its narrative is not audited in the way the financial statements are.
• Companies may say little about competitive matters, and the rules allow them to limit discussion to protect their competitive position.
• A well-written MD&A is not evidence of a good business; a dull one is not evidence of a bad one.

Common mistakes

• Reading the MD&A before the statements, and then seeing the numbers through management's story.
• Accepting explanations without checking the arithmetic.
• Treating outlook statements as forecasts.
• Ignoring how management's past statements turned out.

Try it yourself

1. Read the MD&A of any listed company and mark each sentence about the year as a fact, an explanation or a hope.
2. Pick two explanations and check them against the statements, notes and segment information.
3. Find the MD&A from three years earlier. What did management expect then, and what actually happened?