I am a big fan of non-GAAP metrics, when used properly. When you think about it, almost all the metrics that investors rely on are not defined by either US GAAP or IFRS Standards: EBIT, EBITDA, free cashflow, net debt, organic growth – the list goes on and on. It’s actually a challenge to come up with a list of GAAP metrics that investors do use. There’s revenue and frankly not a lot else.
One could argue that any accounting framework that fails to produce useful metrics has lost its way, but my goal here is look at how non-GAAP metrics work in practice.
Many companies report organic or like-for-like sales growth. I think this is one of the more useful metrics. The usual high-level definition is revenue growth before acquisitions, disposals and foreign exchange movements, but there are many variants. The theory is that organic growth is a measure of how customers rate your products or services. Growth implies customer satisfaction, and shrinkage implies loss of competitive edge. As is often the case, reality can be more complex.
I used to follow an acquisitive industrial conglomerate that claimed to be growing at about 7% organically. There were already numerous warning signs – weak cashflow, a bullying CEO, increasingly expensive acquisitions – but disclosure was good, so I thought I would derive my own organic growth rate. I didn’t have all the data but my estimate was that growth was about 2%, not 7%. The company disputed my estimate, without explaining why it was wrong, and of course complained to my employer.
Some years later I managed to find out the real story. When this company developed a new product, built a production line and started selling it, the revenues counted as organic growth. Fair enough. However, when it decided to discontinue a product and close down the production line, the lost revenue was not counted as organic shrinkage.
Companies that use non-GAAP metrics should explain how they are defined and provide a reconciliation to GAAP numbers
This policy was not disclosed anywhere and was disingenuous at best and, in my book, deliberately misleading. It turned out that the company routinely discontinued 2%–4% of its products every year, resulting in permanently overstated organic growth.
At this stage you may be wondering why the auditors let them get away with it. The answer is that non-GAAP metrics are not usually audited, regardless of how prominently they are displayed. The company was not technically breaking any rules, although I would argue that it was not presenting a true and fair view of the situation.
There are many other potential wrinkles with organic growth. Growth can be boosted by inflation or pass-through of raw material costs. Growth at associates is ignored, as is shrinkage inside discontinued operations. Moving from selling one-off software licences to a subscription model will reduce near-term growth even though the transition may well be very lucrative over time.
There are similar problems with other non-GAAP measures. Consider net debt. Should lease liabilities be treated as debt? What about customer advances? What about provisions for specific environmental liabilities? There is usually no simple answer to these questions.
There is, however, a simple solution that does not involve waiting for the standard-setters to catch up with the status quo. Companies that use non-GAAP metrics (ie almost all of them) should explain exactly how they are defined and provide a detailed reconciliation to the GAAP numbers. They could also then ask the auditors to confirm that the numbers were accurate. This would not eliminate abuse, but it would greatly increase the confidence of investors. It would also shine a spotlight on companies that declined to follow best practice.