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Non-GAAP Earnings

Step-by-Step Guide to Understanding Non-GAAP Earnings

Last Updated December 31, 2023

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Non-GAAP Earnings

Non-GAAP vs. GAAP Earnings: What is the Difference?

Non-GAAP earnings are meant to normalize historical performance and set a more accurate reference point for forecasts to be based upon.

While GAAP attempts to establish uniformity among the financial statements of public companies, it is still an imperfect reporting standard, with instances where GAAP earnings can become distorted.

Namely, there are two types of items that can skew earnings and cause GAAP earnings to be misleading to investors.

  • Non-Recurring Items → Non-recurring items are one-time events that are not part of a company’s core operations. The income and expenses from these sources are not expected to continue into the foreseeable future (e.g., restructuring charges, one-time write-downs, write-offs, gains on sales).
  • Non-Cash Items → Non-cash items refer to items related to accrual accounting concepts, such as depreciation and amortization (D&A), as well as stock-based compensation, where no real cash outflow has occurred.

Both non-recurring items are recorded on the income statement and affect net income (i.e., the “bottom line”).

Since forecasting aims to project a company’s future performance – specifically the cash flow generation from its core operations – removing the impact of these sorts of items should theoretically depict a more accurate picture of past and ongoing performance.

However, note that the validity of each non-GAAP reconciliation must be analyzed because the discretionary nature of these adjustments creates room for bias and potentially inflated earnings.

Learn More → Non-GAAP Financial Measures (Source: SEC)

Non-GAAP Earnings Example: Adjusted EBITDA Metric

In particular, one of the most common non-GAAP metrics is termed “Adjusted EBITDA.”

The adjusted EBITDA metric is commonly perceived as the most accurate measure of core operating performance, as it facilitates comparisons across peer companies, irrespective of varying capital structures and tax jurisdictions.

For instance, the offer values in M&A transactions are often denoted as an EV/EBITDA multiple.

To calculate EBITDA, D&A is added back to EBIT, which is followed by other adjustments, such as removing stock-based compensation.

But to reiterate, these discretionary adjustments can allow companies to conceal poor GAAP operating performance with non-GAAP results.

Therefore, all non-GAAP disclosures and earnings must be viewed with sufficient skepticism to avoid being misled.

Learn More → EBITDA Quick Primer

Management Adjusted EBITDA in M&A

In M&A, a pitch deck or confidential information memorandum (CIM) will, in practically all cases, contain a management-adjusted EBITDA figure.

The management teams of companies are incentivized to illustrate the financial state of their company in the best light possible to maximize their exit valuation, making it critical to remain skeptical to avoid being misled.

Thus, we recommend ignoring management’s figure entirely, at least during the initial stages of analysis, and calculating the company’s EBITDA instead of objectively using your own assumptions.

Once complete, the independently calculated metric can be compared to management’s guidance as a quick “sanity check,” but the more important point is to avoid over-reliance on management estimates.

Starting from EBIT, any adjustments for non-recurring income or expenses are made to get a better sense of the normalized core profitability of the company.

Oftentimes, management-adjusted financial metrics are used by prospective buyers in the preliminary stages of the process until the deal reaches the later stages, during which additional in-depth diligence ensues.

In the diligence phase, the buyer – either a strategic acquirer or financial buyer (i.e., a private equity firm) – delves into the target company’s financials on a far more granular level.

If deemed necessary, the buyer can also hire an independent, third-party firm (typically an accounting firm) to perform a routine quality-of-earnings (QofE) analysis to validate management’s adjustments as the transaction closing date nears.

Non-GAAP Earnings Calculator

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Non-GAAP Earnings Calculation Example

Suppose a company’s income statement prepared under GAAP reporting standards for fiscal year 2021 were as follows:

  • Revenue = $100 million
  • Less: Cost of Goods Sold (COGS) = ($50 million)
  • Gross Profit = $50 million
  • Less: Operating Expenses = ($40 million)
  • Earnings Before Interest and Taxes (EBIT) = $10 million
  • Less: Interest Expense, net = ($5 million)
  • Earnings Before Taxes (EBT) = $5 million
  • Less: Taxes @ 21% Tax Rate = ($1 million)
  • Net Income = $4 million

Given those reported figures, most would perceive the company’s financial results negatively, as its margin profile appears unsustainable.

In 2021, its GAAP-based profit margins comprised a 10% operating margin and a 4% net profit margin.

  • Operating Margin = $10 million ÷ $100 million = 10.0%
  • Net Profit Margin = $4 million ÷ $100 million = 4.0%

But let’s say that management has also provided non-GAAP metrics as part of their disclosures to support their financial statements.

  • One-Time Restructuring Expense = $6 million
  • (Gain) / Loss on Asset Sale = $4 million
  • Stock-Based Compensation = $10 million

All three of those items can be added back by management, resulting in a non-GAAP EBIT of $30 million.

  • Non-GAAP EBIT = $10 million + $6 million + $4 million + $10 million = $30 million

Further, if D&A is $10 million, the adjusted EBITDA would be $40 million.

  • Depreciation and Amortization (D&A) = $10 million
  • Adjusted EBITDA = $30 million + $10 million = $40 million

Per management’s non-GAAP reconciliation, the company’s non-GAAP operating margin is 30%, whereas its adjusted EBITDA margin is 40% – reflecting a financial state much more favorable than what its GAAP financials implied.

  • Non-GAAP Operating Margin = $30 million / $100 million = 30%
  • Adjusted EBITDA Margin = $40 million / $100 million = 40%

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Segun Akinola
March 17, 2023 5:55 pm

GAAP for good and successful

Brad Barlow
March 19, 2023 7:06 pm
Reply to  Segun Akinola

Thanks, Segun

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