With music companies’ fourth quarter earnings starting to roll out this week, news reports have been filled with the usual alphabet soup of accounting jargon, abbreviations and acronyms. It can get confusing, especially since some of the most visible financial metrics don’t have strict definitions.
Spotify, Warner Music Group, Live Nation, SiriusXM and other companies publicly traded in the U.S. adhere to what are called Generally Accepted Accounting Principles set by the Financial Accounting Standards Board. GAAP standards allow investors to reasonably trust companies will fairly represent their business results using the same rules and language. Left to creatively interpret their own finances, companies would have different approaches to measuring their revenue, expenses and liabilities. Given companies’ strong incentive to present attractive numbers to investors, financial reporting without rules would be complete chaos.
Before we get too deep into that, though, a quick review of some basic accounting terms:
- Revenue: a company’s income in a period.
- Cost of sales (or cost of goods sold): the expenses directly related to the company’s revenue (in digital music, for example, cost of sales are mostly the royalties owed to rights owners).
- Gross margin: the difference between revenue and cost of sales.
- Operating income: gross margin minus operating expenses such as salaries, administrative expenses, leases and marketing costs.
- Net income (loss): what’s left after adding and subtracting additional items (such as depreciation, interest expense, losses on asset sales) from operating income.
While a company must adhere to GAAP accounting and reporting standards, it can also use non-GAAP metrics to put a different spin on its numbers. It can choose how to define each metric and will explain its reasonings in its financial statements. Typically, a company’s management looks at net income (loss) as a blunt measure that doesn’t reflect the job they did. Net income incorporates a slew of incomes and expenses beyond selling goods and services and running a business. Removing out-of-the-ordinary expenses helps investors more accurately compare multiple years without looking at large swings in profit and loss.
Management can control a company’s marketing expenses by getting smarter about how it spends money to encourage customers to buy its products. But some expenses are more matters of accounting and financing rather than reflections of profitability and operational effectiveness: the amount of debt a company has on its books, the amount of taxes it owes, or how it calculates depreciation of its long-term assets. So interest on debt, taxes on profit and depreciation expenses are often removed from non-GAAP profit metrics. Notably, depreciation is removed from profit metrics because it’s a non-cash expense.
Here’s a quick rundown of some common non-GAAP metrics used in financial reporting and executive compensation.
Adjusted operating income (AOI)
Live Nation’s preferred non-GAAP metric for evaluating its operating segments is adjusted operating income (AOI), which removes many non-operational items such as depreciation and some stock-based compensation expenses. As the company explains in its financial statements, AOI also excludes amortization of non-recoupable ticketing contract advances (which Ticketmaster used to secure clients) and severance and compensation expenses related to companies it acquires. Live Nation’s performance-based compensation is based on its AOI. For example, in 2020, CEO Michael Rapino’s cash bonus was based on a target AOI. He did not receive a bonus in 2021 because Live Nation failed to meet targets set prior to COVID-19’s effect on the business.
Operating income before depreciation and amortization (OIBDA)
Warner Music Group prefers to gauge its performance using operating income before depreciation and amortization, shortened to OIBDA (pronounced oy-ba-da). WMG adjusts operating income to remove items such as amortization of intellectual property — the cost of recorded music and publishing catalog. GAAP requires companies to calculate depreciation and amortization expenses to reflect the assets’ loss of value over time. For accounting, the company benefits because depreciation and amortization reduce taxable income; but for reporting, management would rather investors and analysts not consider them when judging the company’s profitability.
Free flow cash (FCF)
To calculate executives’ performance-based bonuses, WMG uses another non-GAAP metric, free cash flow (FCF), which the company defines as “cash flow from operating activities minus capital expenditures.” Cash generated from financing (such as money received from the sale of bonds) and investments (like money spent buying a factory) aren’t considered here. As WMG explained in its Jan. 19, 2022, proxy statement, FCF provides a perspective on the cash available to run the business and “is a significant measure of our ability to generate long-term value.” It can also provide an easy way to calculate a bonus. In the fiscal year ended Sept. 30, 2021, Max Lousada, CEO of recorded music, received 1% of the “free cash flow bonus pool” in fiscal 2021, equal to $2.18 million. Other executives’ bonuses were based on a different mix of criteria.
Earnings before interest, taxes, depreciation and amortization (EBITDA)
One of the most common non-GAAP profit metrics is earnings before interest, taxes, depreciation and amortization, shortened to EBITDA (pronounced ee-bit-da). In addition to the non-cash items excluded from AOI and OIBDA, EBITDA excludes two cash expenses: taxes owed on profits and interest paid on long-term debt. Although taxes and interest are incurred in the everyday course of business, they don’t necessarily reflect management’s effectiveness in running a company. EBITDA is handy for comparing companies of various ages and sizes because it removes the effects of debt and assets on net profit. Analysts and investors commonly value a company by applying a multiple to its EBITDA — a high-growth company could easily be worth 25 to 30 times EBITDA while a low-growth firm might be worth a 10 or 12 EBITDA multiple.
Accounting rules require companies to take an expense from some non-cash, “extraordinary” items that don’t occur in the normal course of business. For example, if a company decides to sell an underused building at a loss, the amount of the deficit would appear on the income statement as a loss against profit — even if the sale was a sensible decision that generated much-needed cash. A company also incurs a charge if it lowers the valuations of an asset and investment. Without adjusting EBITDA to remove the impairment charge, investors would have a harder time comparing 2021 to previous years, and executives might not meet the EBITDA criteria of their performance bonuses.
SiriusXM believes non-GAAP measures, such as adjusted EBITDA and FCF, “may be useful to investors in evaluating our core trends because they provide a more direct view of our underlying costs.” Its executives’ annual performance bonuses in 2020 were based on adjusted EBITDA and other factors that varied by executive. EBITDA was adjusted to remove such items as share-based compensation expense and impairments to asset values, according to the latest annual report.