G-Squared Partners: GAAP vs. Non-GAAP Financials
Imagine a business that needs a loan or equity investment and provides potential lenders and investors with financial statements that disclose only what management wanted to disclose, computing revenues, margins, receivables, and other items in a way that was flattering but incomplete. As this would not offer an honest picture of the company’s financial health, it is doubtful that anyone would be willing to lend or invest capital in the business.
Untrustworthy financial information could derail the critical process of directing investors’ capital to legitimate businesses. To overcome this problem, Generally Accepted Accounting Principles (GAAP) standardize financial reporting, allowing investors to understand a company’s financial status and make meaningful comparisons across companies and over time. So, it is fair to say that GAAP (and its equivalent outside the U.S., International Financial Reporting Standards) helps to keep capital flowing throughout the economy.
However, GAAP reporting can create problems for those who want to use a company’s balance sheet and income statement to evaluate the current state of the core business, including how sales are doing, whether the company is generating cash or burning through it, etc. So, in addition to GAAP-based financials, many companies – large and small – publish supplementary views known as non-GAAP reporting. At the end of 2017, 97% of the companies in the S&P 500 reported at least one non-GAAP indicator in their financial statements. In this article, we discuss common reasons companies use non-GAAP reporting, and why it can make sense to do so.
Adjusted EBITDA
Adjusted EBITDA removes various non-recurring items from EBITDA to produce a number that is not distorted by gains, losses, or expenses that do not affect cash or are one-time items. The adjustments made to EBITDA can vary widely by industry and may include:
- Non-cash expenses, some related to the timing of revenue recognition
- Unrealized gains or losses
- Non-operating income (e.g., from securities held in an investment portfolio)
- One-time realized gains or losses
- Litigation expenses
- Goodwill impairments
- Asset write-downs
- Foreign exchanges gains or losses
- Stock-based compensation charges
Non-cash or cash, one-time or ongoing?
One of the key differences between GAAP and non-GAAP reporting is the treatment of non-cash expenses. GAAP requires companies to deduct non-cash expenses – the value of stock options granted to key employees is probably the most common example – to determine profits. Such expenses reduce income (and possibly income taxes) but do not affect cash flow. Many investors focus primarily on a company’s ability to generate cash, or how quickly it is using up its cash, and that analysis becomes more challenging when net income is not closely related to cash flow. For this reason, non-GAAP adjustments often reverse non-cash expenses.
Some people argue that this gives companies too much flexibility in presenting their financials in a way that is perhaps overly positive. For example, if a company awards key employees with restricted stock units every year as part of the package it offers to attract and retain talent, there is an argument to be made that this is part of the company’s compensation expense, along with salaries and benefits.
Another common focus in non-GAAP reporting is excluding one-time cash expenses, such as costs related to an acquisition, restructuring, or R&D. This smooths out GAAP-based earnings that may be volatile due to one-off events, providing a clearer picture of the earnings generated by core business activities. Many young companies, including many in the life sciences industry, do not show a profit for many years as they pour money into research to create products that will generate revenues far into the future. That lack of earnings reported under GAAP today could lead investors to turn away from tomorrow’s blockbuster profits.
However, some companies (Uber is often used as an example) publish non-GAAP earnings that exclude recurring costs incurred to aggressively pursue market share in a highly competitive market. Companies argue that such expenses will not persist indefinitely and therefore should be excluded when evaluating how profitable the business is likely to be on an ongoing basis; however, the cash is going out the door as part of the core business strategy. Such practices may or may not be defensible, so investors must determine for themselves which non-GAAP adjustments are reasonable and which are not.
GAAP versus real-time
GAAP’s rules require revenues and expenses to be recognized over time. While this is actually logical and defensible (especially to accounting professionals) it produces financial statements that can fail to provide a clear picture of how a business is doing right now. Getting a clear picture of quarterly sales growth and cash outflows requires us to make some adjustments.
Consider a SaaS software company that brings in a $100K one-year contract just before quarter-end. The income statement for that quarter is not affected because the sale is not recognized until the service begins. GAAP requires revenue to be booked over the life of the contract, even though the customer is billed for the full amount after 30 days, so each month the company’s sales include $8K from the new contract ($100K ¸ 12). However, there is no cash coming in for 11 of the 12 months, because the full amount was paid in Month 1. Therefore, in Months 2 through 12 a portion of revenue does not contribute to cash flow, and it is difficult to figure out from the financial statements that the company’s annual revenues grew by $100K this quarter.
Now let’s assume this company pays a 10% commission to the salesperson who made the sale. If the company pays the commission as a lump sum upfront, the entire amount is paid in Month 1 but the GAAP statements show a non-cash compensation expense for the next 11 months. The income statement is out of sync with the timing of the impact of the sales commission on the company’s cash outflows.
Many companies award stock options to key employees. These option grants require companies to report an expense but involve no cash outflow. The fair market value of the options must be recorded and amortized as an expense over the vesting period (typically four years). This non-cash expense can be non-trivial, especially for start-ups and other small companies. While these options do represent an economic cost to the company, they do not affect the rate at which the business is using up cash. In some cases the GAAP treatment of this expense and other non-cash expenses could make a company appear to be unprofitable even if it is cash flow positive, affecting how potential lenders and investors evaluate the health of the business.
Focus on KPIs
Since balance sheets and income statements that are prepared using GAAP often do not reflect what investors need to know about a business, making it even more important to compute and monitor useful KPIs. CEOs should focus more on KPIs and less on GAAP-based financial metrics to actually manage the business, evaluate performance, and tell the company’s story. For example, use KPIs to show potential lenders and investors the aggregate value of new sales during a given period, the changes in recurring revenues and contract renewal rates, and new cancellations. This can show that the company is generating new sales at a healthy clip, even though monthly GAAP revenues look fairly stable.
Of course, it is important to be crystal clear in presenting non-GAAP reports. If revenue for a new annual service contract is reported in a lump sum in a non-GAAP report, be sure to show the sales commission that is paid upfront, and note that cash expenses associated with providing the service to the customer as required by the contract will be incurred over the next 12 months.
Key takeaway
Financial statements prepared using GAAP tell a story, but not the whole story. That prompts many companies, large and small, public and privately held, to issue supplemental, non-GAAP reports that can provide important insights. Of course, since management has tremendous discretion about the way non-GAAP statements are prepared, it is important to be selective when using that information and fully disclose what adjustments are being made.
G-Squared Partners can help you to determine whether issuing non-GAAP reports would support your company’s story, or evaluate whether the non-GAAP reports you are currently preparing are doing the job well. Contact us or book a meeting to discuss how we can help.
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