Narrative reporting content in Annual Reports / 10Ks – the ‘MD&A’ - is receiving growing focus from investors and regulators alike. Preparers are increasingly being asked to focus on the matters most relevant to the future of their business, rather than following a list of prescribed disclosures. The result is much greater emphasis on the business model and strategy as a basis for reporting. But building a report around your business strategy can be daunting without the comfort-blanket of a disclosure checklist. For those that succeed, the potential reward is a more concise report that is focused on the key drivers of business value – one that is better equipped to support an effective investor dialogue.
We look at what makes a good report. Whilst we use the Integrated Reporting Framework as a reference point, our suggestions are relevant to other business-centric approaches to reporting such as the UK’s strategic report.
Step back from the reporting detail and think about what really drives value in your business. For many there will typically be three or four key assets or resources which provide a unique competitive advantage. These assets will be different for every business and may lie in areas such as the customer base, brand, intellectual property, expertise, access to natural resources, and for some, their license to operate. Very often they will not be reflected in the balance sheet – and it would not be helpful to try to do so. As a result, their importance to the business is not reflected in financial reporting.
These are the assets that lie at the heart of the business’s ability to generate future earnings. Progress in developing and maintaining them is fundamental to the long term value of the business. This needs to be reported on so that the value being added by management initiatives and the long term prospects of the business can be fully understood.
The starting point for explaining this should be a description of the assets themselves – what they are, why they are important to the business, and whether the business can rely on the continued availability of the asset. From this foundation, readers will want to understand how these assets fit with the changing needs of the business and its operating environment. They will want to see the extent to which they have been developed to meet these requirements. Take, for example, a business that is dependent on a core customer base. A good measure of how this asset is being preserved might be levels of customer retention.
What constitutes a good year for your business? It’s likely to be more than just meeting your earnings objectives. Progress made in implementing the business strategy will most likely feature in the assessment, as will progress in building your key business assets, and managing your key risks. Readers need to understand these factors to make an assessment of performance that takes in long term as well as short term value.
Providing this broader view of performance will often require you to look beyond purely financial measures (though financial measures such as growth in target markets can still be very relevant). These measures should typically align broadly with the measures that management is using itself to monitor performance.
A good illustration of this approach can be seen in the pharmaceuticals industry where research and development progress is such a key element of performance. Here, many companies provide an overview of their development pipeline enabling readers to see progress through the different stages of development through to regulatory approval.
The relevant measures will be different for every business. Finding the right ones to support a more complete picture of performance can require careful thought. Too much information and commercial sensitivities are exposed; too little information and the reporting will lack the detail to influence readers’ decision making.
If shareholders are to take a longer term perspective on business value they will need the information to take that view – but businesses are naturally wary of publishing earnings or other forward looking projections. Not least because they may imply a degree of certainty that management simply cannot provide.
A better approach is to help shareholders form their own informed views of future prospects by providing the information to help them take these judgements. This means helping readers understand the factors likely to drive future earnings, and helping them understand the potential impact that these factors might have. We see an element of this with companies’ risk reporting but there can be a tendency to focus on downside risks to the existing business rather than providing a balanced perspective on risks and opportunities to the future business model. For example, if a key part of your strategy involves growing a particular market, readers will need to understand the opportunity being targeted as well as the challenges the business faces in achieving this.
Readers also need to understand the potential impact that these factors may have on future earnings. A number of companies are now helping them do this by providing sensitivity analysis (for example on exchange rates or materials prices) based on current year earnings to help readers understand the impact that external factors might have on their business.
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