Non-GAAP Financial Measures

Why This Matters

Non-GAAP financial measures are everywhere in earnings releases, investor presentations, and analyst reports—and the CFA exam expects you to understand both their analytical value and their potential for manipulation. You're being tested on your ability to evaluate why companies choose specific adjustments, how these measures differ from GAAP equivalents, and when management might use them to present an overly optimistic picture of performance.

These measures connect directly to core concepts in financial statement analysis: earnings quality, cash flow sustainability, comparability across firms, and management reporting incentives. The best analysts don't just accept non-GAAP figures at face value—they reverse-engineer the adjustments to assess whether they provide genuine insight or obscure underlying problems. As you study these measures, don't just memorize definitions—know what each measure reveals, what it hides, and how to critically evaluate management's choices.

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Cash Flow and Liquidity Measures

These measures strip away accounting accruals to focus on actual cash generation. The underlying principle: cash flow is harder to manipulate than earnings and better reflects a company's ability to fund operations, pay dividends, and service debt.

Free Cash Flow

• Operating cash flow minus capital expenditures—represents cash available for discretionary uses like dividends, buybacks, or debt reduction
• Flexibility indicator that shows whether a company can self-fund growth or must rely on external financing
• Watch for manipulation through capitalizing expenses, timing of CapEx, or inconsistent definitions of "maintenance" vs. "growth" capital

Funds from Operations (FFO)

• REIT-specific measure that adds depreciation and amortization back to net income while excluding property sale gains/losses
• Addresses the mismatch between GAAP depreciation (which reduces earnings) and real estate's tendency to appreciate over time
• NAREIT standardized definition improves comparability, but watch for "adjusted FFO" variations that may exclude recurring expenses

Net Operating Income (NOI)

• Property-level profitability calculated as rental revenue minus operating expenses, excluding financing and corporate overhead
• Capital structure neutral—allows comparison of properties regardless of how they're financed
• Key input for cap rates ($\text{Cap Rate} = \frac{\text{NOI}}{\text{Property Value}}$), making it essential for real estate valuation

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Profitability Measures Excluding Non-Cash Items

These measures remove depreciation, amortization, and other non-cash charges to approximate operating cash generation from the income statement. The logic: non-cash charges don't affect current liquidity, so excluding them may better reflect ongoing operational performance.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

• Proxy for operating cash flow that facilitates comparison across companies with different capital structures and tax situations
• Widely used in valuation multiples ($\text{EV/EBITDA}$) and debt covenants because it's capital-structure neutral
• Overstates cash available by ignoring CapEx requirements, working capital needs, and the real economic cost of asset consumption

Adjusted EBITDA

• Further excludes "non-recurring" items like restructuring charges, stock-based compensation, and acquisition costs
• Red flag territory—examine whether excluded items truly are non-recurring or represent ongoing business costs
• Stock-based compensation exclusion is particularly controversial since it represents real dilution to shareholders

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Per-Share and Earnings Quality Measures

These measures aim to present a "cleaner" view of profitability by excluding items management considers non-representative. The analytical challenge: distinguishing between adjustments that genuinely improve insight and those designed to inflate apparent performance.

Adjusted Earnings Per Share (Adjusted EPS)

• Excludes one-time charges and gains to show what management considers "normalized" profitability
• Typically higher than GAAP EPS—studies show companies rarely adjust for positive non-recurring items
• Reconciliation required by SEC Regulation G; always compare the adjustment trend over time to assess earnings quality

Core Earnings

• Isolates primary business operations by excluding peripheral activities, discontinued operations, and non-operating items
• S&P developed a standardized definition that includes pension costs and stock compensation—often stricter than company-reported figures
• Useful benchmark for comparing company-reported "adjusted" earnings against a more objective standard

Adjusted Net Income

• Net income restated for non-recurring items—the starting point for calculating Adjusted EPS
• Examine the pattern of adjustments—if "non-recurring" charges appear every year, they're effectively recurring operating costs
• Quality of earnings analysis requires tracking the cumulative difference between GAAP and adjusted figures over multiple periods

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Growth and Performance Measures

These measures isolate organic business momentum from growth achieved through acquisitions, new locations, or other external factors. The principle: sustainable growth from existing operations is generally higher quality than growth requiring continuous capital deployment.

Same-Store Sales (Comparable Store Sales)

• Revenue growth from locations open at least 12 months—excludes newly opened and closed stores
• Key health indicator for retail that reveals whether existing operations are strengthening or weakening
• Cannibalization risk—new store openings may boost total revenue while same-store sales decline as locations compete

Organic Growth

• Internal growth excluding acquisitions, divestitures, and currency effects—shows underlying business momentum
• Higher quality than acquired growth because it doesn't require premium purchase prices or integration risk
• Decompose total growth into organic vs. inorganic components to assess management's capital allocation effectiveness

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Quick Reference Table

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Self-Check Questions

1. A company reports Adjusted EBITDA that excludes stock-based compensation every quarter. Why might an analyst add this expense back when comparing the company to peers, and what does this adjustment pattern suggest about earnings quality?

2. Which two measures would be most appropriate for comparing the operating performance of REITs, and why are standard profitability measures like net income less useful for this industry?

3. Compare and contrast Free Cash Flow and EBITDA as measures of cash generation. Under what circumstances might EBITDA significantly overstate a company's ability to generate cash?

4. A retail company reports 8% total revenue growth but 2% same-store sales growth. What does this divergence tell you about the source of growth, and what follow-up questions should an analyst ask?

5. If an FRQ asks you to evaluate the quality of a company's non-GAAP earnings adjustments, what three specific patterns or red flags would you look for in the GAAP-to-non-GAAP reconciliation?