Why Bankers Should Do Their Homework on Non-GAAP Metrics

Many companies report financial metrics that don’t conform to U.S. Generally Accepted Accounting Principles (GAAP), such as earnings before interest, taxes, depreciation and amortization (EBITDA), in their business plans and other promotional materials. These figures can sometimes cast a more favorable light on the borrower’s historic and prospective operations than the GAAP figures do. So, do your homework before banking on non-GAAP metrics.

GAAP is king

GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission requires public companies to follow it. Many bankers expect private borrowers to follow suit, because GAAP is familiar and consistent.

Such consistency enables bankers to compare financial statements from different companies and make informed credit assessments. Another principle underlying GAAP is conservatism. This principle aims to match revenue and expenses within a reporting period and helps prevent borrowers from overstating profits and asset values.

Asking questions is key

Some business owners argue that non-GAAP figures provide more meaningful proxies of financial performance than GAAP net income. And they use these figures to provide additional information about their company and financial results. Other companies, however, manipulate or cherry-pick non-GAAP metrics to mislead unwary investors and bankers.

When relying on a non-GAAP figure, it’s important to ask how it differs from the corresponding GAAP metric. For example, you might ask a borrower to show how it calculates EBITDA and then reconcile EBITDA to GAAP net income. Some companies may exclude certain types of owners’ compensation from EBITDA. Or they may exclude one-time losses — but include one-time gains — in EBITDA.

Other questions to consider include:

• What added insight does the non-GAAP figure provide beyond what’s provided in the borrower’s GAAP financial statements?
• Does the company give the non-GAAP figure more prominence than the corresponding GAAP figure in the business plan or marketing materials? If so, why?
• How does management use the non-GAAP figure in-house?
• Is the non-GAAP figure used to determine management compensation or bonuses?
• Has the non-GAAP figure been used in previous reporting periods? If so, was it calculated using the same formula?
• Do other companies in the borrower’s industry report similar non-GAAP metrics?

If a non-GAAP figure doesn’t matter to management or isn’t used by competitors, it may not be meaningful to the company’s banker either.

Caution is critical

Non-GAAP measures should supplement, not supplant, GAAP measures, according to the Center for Audit Quality, a nonprofit public policy organization of accounting professionals. Remember, no one usually audits or reviews non-GAAP measures. So bankers should exercise caution when relying on them to make credit decisions.

For more information on Smith and Howard’s commercial banking services, please contact Paul Atkinson at 404-874-6244.