What are Non-GAAP Earnings?
Non-GAAP earnings are earnings measures that do not follow GAAP’s (Generally Accepted Accounting Principles) standard calculations and are not required for external reporting or disclosing. However, non-GAAP earnings are typically reported in company filings with the Securities and Exchange Commission (SEC), and they can be used internally to make managerial decisions or to evaluate managers.
GAAP Earnings vs. Non-GAAP Earnings
To understand non-GAAP earnings, it is important to understand GAAP earnings and how to calculate GAAP earnings. GAAP is a set of standard accounting rules that companies that file under the SEC must comply with for their company filings. Also, companies are audited to ensure that they are following GAAP’s rules in their reporting.
GAAP aims to keep accounting practices consistent when making company filings. It ensures market participants that they will be able to analyze the companies’ financial statements on a level playing field and that companies prepared their earnings using the same set of accounting rules.
Why are Non-GAAP Earnings Reported?
At the basic level, non-GAAP earnings are reported because management may find it to be a more suitable way to depict the company’s earnings. An example would be if a company incurred a large one-time expense, they would need to report that expense under GAAP rules.
However, they may report a pro-forma statement or adjusted earnings statement, which would mark the large expense as a one-time expense and would not include it in normal operating income. Thus, the discrepancies between non-GAAP and GAAP earnings might be large.
Another reason that companies use non-GAAP earnings is to show investors the management’s views on its core operations.
Significance of Non-GAAP Earnings
The use of non-GAAP earnings in SEC filings is at its highest. In 1996, 59% of S&P 500 companies used at least one non-GAAP earnings measure, whereas, in 2018, 97% of S&P 500 companies used at least one non-GAAP earnings measure in company filings. The use of non-GAAP earnings, in part, increased because of the increase in large non-reoccurring expenses. For example, from 1996 to 2018, the number of mergers and acquisitions worldwide increased by 116%.
In addition, investors pay close attention to non-GAAP earnings, as it provides insight into how management believes its core operations are performing. However, non-GAAP earnings may be misleading when incorrectly used. A company may include significant non-reoccurring costs in every filing, which can suggest the company is attempting to inflate its non-GAAP earnings.
Also, non-GAAP earnings aren’t suitable for companies that must frequently upgrade costly equipment, as it may be labeled as a non-operating expense. Consequently, investors must be critical when analyzing non-GAAP earnings.
Common Non-GAAP Earnings Measures
The following are non-GAAP earnings measures that are frequently used:
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is one of the most popular non-GAAP earning measures. EBITDA is used as a cash flow measure that the company receives from operations. It is a proxy for a company’s profitability.
For companies with significant PP&E, their EBITDA figure can be quite different from their GAAP earnings because of the depreciation of PPE. EBITDA also evaluates a company independent of its financing decisions and taxation.
The EBITDA metric is calculated by adding interest expense, taxes, depreciation, and amortization to the company’s net earnings, as seen below:
EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization
Free Cash Flow (FCF)
Free cash flow (FCF) is a commonly used non-GAAP earnings measure that shows cash flows a company receives that are available for distribution among all securities holders of the company. FCF measures profitability, excluding non-cash expenses from the income statement, but includes changes in net working capital and capital expenditures.
FCF can be calculated by using many methods, including the one below:
Free Cash Flow = Cash Flow from Operations + Interest – Interest Tax Shield – Capital Expenditures
Pro-forma earnings exclude certain costs or expenses that the company believes don’t accurately represent its profitability. The earnings may not include large expenses that the company does not believe to be reoccurring. i.e., purchasing a new building. Also, pro-forma earnings are typically used to show investors what management thinks their true operating income is.
Non-GAAP earnings tend to face criticism because they are almost always higher than GAAP earnings. Critics believe that non-GAAP earnings exclude reoccurring costs by labeling them as non-reoccurring or one-time expenses.
In addition, non-GAAP earnings are not standardized, making it difficult to compare such type of earnings from different companies. Thus, investors should look at non-GAAP earnings with a critical eye.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: