Non-GAAP Earnings

GAAP, or generally accepted accounting principles, is a reporting rule and standard used for the financial statements of a publicly listed company.

Non-Gaap earning is a method of reporting used alongside GAAP by a company when they believe that specific GAAP metrics do not fully represent the company's true position as desired by the management for investors.

GAAP standard is recommended by the regulators as it brings a common standard of financial reporting which helps the investors to compare companies. 

But sometimes management thinks that GAAP results do not reflect the true status of the company and use Non-GAAP metrics alongside GAAP.   

For example, if a company reports an earning of $15 million under GAAP but there was a one-time investment of $6 million during the financial year. 

The management thinks this is not reflective of the real operation of the business as it's a large one-time investment that does not happen every year. 

So the management will use the Non-GAAP metric to adjust this expense and show an earning of $21 million alongside official GAAP reporting. 

Frequently Used Non-GAAP Earnings Measures

There are many metrics used by the management to give investors different insights into the financial health of a company.

Following are some examples of these metrics used frequently for financial disclosure. 

1. EBITDA or Earnings before interest, taxes, depreciation, and amortization.

EBITDA is the most popular non-GAAP metric used for financial reporting. It represents adjusted earnings that companies report before subtracting all non-cash expenses (depreciation and amortization), taxes, and debt costs

EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization

It also represents the company's generating potential as it excludes all non-cash expenses and helps the investors to compare the performance of different companies more accurately, as different companies may have different depreciation methods and different tax obligations.     

2. Free Cash Flow (FCF)

Free Cash Flow (FCF) is used to get an idea of how much cash a company generates from its operations after deducting capital expenditures. It serves to benefit investors, creditors, and reinvestment operations.

FCF = Operating Cash Flow - Capital Expenditures
 or
FCF = Cash Flow from Operations + Interest – Interest Tax Shield – Capital Expenditures

Positive FCF indicates that the company is generating more cash from its operation than it is spending on capital expenditure and surplus cash to use in reinvesting or paying dividends to the investors. 

3. Adjusted Earnings 

Adjusted Earning is used for many different financial indicators like operating income, gross profit, operating margin, or net income. The main purpose of adjusted earnings is to adjust the non-recurring or non-operational expenses.

If a company has a big non-recurring expense like the acquisition of another company, the management uses adjusted earnings to tell investors financial figures without the acquisition cost as it is a one-time expense and not an operational expense. 

4. Same-Store Sales

Same-Store sales are mostly used by companies that have physical retail chains. This metric excludes the sales of new locations opened in the middle of a financial year and the sales generated from stores that were closed during the same period.  

This helps the investors to get an idea of the performance of established outlets and how new outlets and closed outlets impact the sales metrics of a company.

How EBITDA is used in financial reporting

EBITDA is one of the most popular Non-GAAP metrics used for measuring a company's performance.

Let's look at the example of Uber and see how it uses EBITDA in its financial reporting. As it is a public company, it has to publish its financial reports to its investors and the public to look at the performance and financial health of the business.  

Uber is one of the largest ride-hailing companies, it also has other businesses like Uber-Eats and Postmates. It had its IPO in 2019 but never had a portable year since 2014 (except for 2018, when it sold its market share in China, Russia, and SouthEast Asia). 

It uses Adjusted EBITA for its targets and the main performance metrics. Let’s look at how Uber described adjusted EBITA in its 2022 annual report. 

Source: Uber annual 2022 financial report

Above is the description given by Uber in their 2022 annual report on how they describe adjusted EBITDA. We can see there are more deductions than your normal tax, depression, and amortization.

Below is the Adjusted EBITDA reconciliation of Uber. We can see that in 2022 they had a loss of 9,141 million USD, but after all the adjustments, the adjusted earnings came to be a profit of 1,723 million USD.

Below is the statement from Uber management in their proxy annual report for 2022.

We can see how the management is using EBITDA and free cash flow as their performance benchmarks.

Now it’s up to the investors to look at this figure and determine whether it's relevant to them or not. But this shows how these metrics when looked at in a vacuum, can distort the real picture.

Criticisms of Non-GAAP Earnings

Even though Non-GAAP reporting is widely used it is not without criticisms. My investors and regulatory bodies think that the use of Non-GAAP earnings should be regulated and should have a clearly defined rule on which items can be included and excluded from the calculations. 

In recent years companies like Uber have been certified heavenly for their use of Non-GAAP metrics for their reporting and deceiving inexperienced retail investors. 

The most common problem with allowing the non-GAAP standard is that the CEOs and management will use the metrics that make them look good, which is opposite to the fundamental idea of accounting. 

Following are some major criticisms se:

1. Lacks standardization

Non-GAAP reporting standards are not governed by any entity or have any defined set of rules, this leads to inconsistency in reporting between different companies. As the management can pick and choose what data is to be excluded from the final reporting.

2. Manipulation and False Reporting

As management has full discretion in using these metrics, there is potential for manipulation and false reporting. As most management has performance-based compensation, there is an incentive for this type of misleading reporting.

3. Lack of comparability

As this reporting standard lacks standardized rules, different companies can use different variables in their statements. This leads to different companies having different reporting variables even in the same industry.

And because of this, investors can have difficulty comparing competitors when doing their investment research. 

4. Lack of Transparency and misleading information
As it excludes big expenditures as non-operational and non-recurring expenses, it may give the investors a misleading idea about the financial health of the company. And this can also lead to a situation where management is not transparent about their performance. 

Non-GAAP reporting is useful when used alongside other reporting standards, which are standardized like GAAP and IFRS, to get the final value of a company.

It gives a different perspective on a company's financial health but should not be used as stand-alone data to value a company. 

You can take the help of the SEC website to know more about how public companies are required to publish their GAAP and Non-GAAP Financial reports.

Researched and authored by Kunal Raj | LinkedIn

Reviewed and Edited by Arnav Singh | LinkedIn

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