Just before Christmas, I attended a conference on financial reporting that contained a very interesting segment from a leading sell-side analyst¹.  The content of his talk was what do analysts want from financial reports.  He quite frankly said that ‘they don't know 50% of time'.  However, there followed 45 minutes or so of very useful insight that those preparing or starting to think about annual statements might like to bear in mind.

Historically investors have been interested in margins and growth opportunities but the recent financial crisis has caused more focus on sustainability of cash flows, debt coverage, the impact of foreign currency movements, hedging policies and operational gearing (% of costs that are fixed in the short to medium term).

On the other hand foreign exchange translation differences, actuarial gains and losses, revaluations and hedging balances carried forward are generally ignored by the analyst when making his or her decision on the attractiveness of the company to a potential equity investor.  Deferred tax has always been an area that has ‘lost' me in its meaningfulness and I was heartened to hear that most analysts simply treat deferred tax balances as equity i.e. they ignore it.

It was illuminating to hear what actually happens on the day of a results announcement.  Results are available at 7am and by 7.15am the analyst is expected to have formed a view on the stock and be briefing colleagues.  Even though the analyst in question will know the company very well that still only leaves 10 minutes to review the financial report (it takes 5 minutes or so to download and print the announcement before hurrying to the briefing room without spilling the coffee).  It is not surprising then that it is the high level issues that are concentrated on.  It also highlights the need for preparers to produce clear and concise commentaries that quickly focus on these main issues.

After the initial hiatus of activity there is time for a more reflective approach and areas that then get more attention are:

• - Operating cash flow compared to operating profit
• - Working capital movements (there was a plea not to aggregate this movement but to provide a reasonable amount of detail)
• - Net debt (companies should show a reconciliation of movements in net debt)
• - Tax (are tax rates sustainable, divergence between effective v cash-tax rates, the degree of certainty of tax provisions, clear explanation of unusual tax items and meaningful reconciliations including a reconciliation of the geographic weighted average tax charge and the actual tax charge)
• - Business combinations (the analyst would like to see the impact of the first full year irrespective of when the purchase actually took place as well as a clear analysis of the impact on the cash flow statement by line item)

In the present economic climate with a heightened focus on survival five areas were highlighted as key to the assessment of the financial strength of the company:

• - Pensions (what are the future cash flows anticipated to be)
• - Balance sheet strength (how well is the organisation equipped to cope with a double dip recession, if it occurs)
• - Capital raising ability (is the company near to banking covenant thresholds, does the company have unused lines of credit, how likely is it to be able to negotiate rollovers of existing credit or generate new lines of credit)
• - Stock options (what has been granted to date and when are they likely to mature)
• - Leases (these are another form of debt and in the case of operating leases off-balance sheet)

So now we know what one leading analyst looks for when reviewing financial statements.  Remember first impressions are important and it is what the analyst finds in the first ten minutes of looking at your preliminary announcement that will shape the way the market initially reacts which will often set the tone for the rest of the day's trading.  Months of work, I know, distilled down into a few minutes analysis - well it puts into perspective that debate on whether the comma on page 5 should really be a semi-colon ! 

¹ A sell-side analyst typically works for a firm that sells general investment services to asset management companies and individuals.  A buy-side analyst typically works for the asset management company and makes specific recommendations to investors or asset managers on which shares to buy, hold or sell.