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CFA Level II Exam · Evaluating Quality of Financial Reports

Non-GAAP Measures and Quality of Balance Sheet and Cash Flows

Updated 7 October 2026 · Fact-checked

Non-GAAP (or non-IFRS) measures are company-defined figures such as adjusted EBITDA that depart from reported standards. To assess quality, check the reconciliation to the reported figure, what is excluded, and whether cash flow and balance sheet items support the reported earnings. Poor disclosure or recurring exclusions signal low quality.

Understand Non-GAAP Measures and Quality of Balance Sheet and Cash Flows

Reported earnings are only one view of performance. Analysts also test whether the cash flow statement and the balance sheet back up those earnings. If they do not, earnings quality is questionable.

Non-GAAP measures (called non-IFRS or alternative performance measures outside the US) are figures that management defines itself, such as adjusted EBITDA, adjusted net income or free cash flow. They can help you see underlying results. They can also hide recurring costs. Regulators, such as the SEC in the US, require that the measure be labelled clearly, reconciled to the nearest reported measure, and not be given more prominence than the reported measure.

Cash flow quality asks whether operating cash flow (CFO) is high quality. Signs of good quality: CFO is positive and consistent with net income over time, comes from core operations, and is not boosted by one-offs. Warning signs: CFO well below net income, CFO growth coming from stretching payables or selling receivables, shifting items between operating and investing or financing, and capitalising ordinary operating costs, which moves outflows from CFO to investing.

Balance sheet quality asks whether the statement is complete, and whether values are reliable. Assets are better when they are measured at observable fair values and are clearly recoverable. Weak signs include unusual growth in receivables or inventory relative to sales, large goodwill or intangibles, level 3 fair values, and liabilities that are understated. Off-balance-sheet items such as special purpose entities, guarantees, factoring with recourse and sale-and-leaseback structures can hide leverage. Operating leases were off-balance-sheet for lessees under both IAS 17 and US GAAP before ASC 842. Today the two frameworks differ in how they treat the lessee.

  • IFRS 16 uses a single finance-type model for lessees. The lessee recognises a right-of-use asset and a lease liability, and the expense is depreciation plus interest.
  • ASC 842 (US GAAP) also puts operating leases on the balance sheet as right-of-use assets and lease liabilities. But operating leases keep a single straight-line lease expense, and the related cash outflow stays in operating activities. Finance leases under ASC 842 are treated with depreciation plus interest.

Adjust debt and ratios for remaining off-balance-sheet items when you compare companies, and be careful when comparing IFRS and US GAAP lessees.

Key formulas to remember

Cash flow to earnings check
CFO ÷ Net income
A ratio persistently below 1 suggests earnings rely on accruals. Judge over several periods, not one.
Accruals ratio (balance sheet method)
(NOA end − NOA beginning) ÷ average NOA
NOA = net operating assets = (total assets − cash and marketable securities) − (total liabilities − total debt). A high or rising ratio signals lower earnings quality. There is no absolute threshold, so compare the ratio with peers or the industry, and look at its trend over time.
Accruals ratio (cash flow method)
[NI − (CFO + CFI)] ÷ average NOA
This is the cash flow accruals ratio as presented in the CFA curriculum. It uses cash flow from operations and investing, and divides by average NOA. NOA = (total assets − cash and marketable securities) − (total liabilities − total debt). Higher means earnings are less supported by cash. There is no absolute threshold, so compare the ratio with peers or the industry, and look at its trend over time.
Free cash flow to firm check
FCFF = CFO + Interest × (1 − t) − FCInv
Add back after-tax interest only when interest paid is included in CFO (US GAAP, or IFRS if the company chooses). Under IFRS, if interest paid is in CFF, CFO already excludes it and no add-back is needed. Normalise before comparing companies.
Non-GAAP reconciliation rule
Reported measure ± listed adjustments = non-GAAP measure
Regulators such as the SEC expect the non-GAAP measure to be reconciled to the nearest reported measure, with each adjustment listed and the tax effects of the adjustments disclosed. Requirements differ by jurisdiction, so treat this as a regulatory expectation, not a universal rule. As an analyst, check that the adjustments are listed and that tax effects are shown.

How to solve Non-GAAP Measures and Quality of Balance Sheet and Cash Flows questions

Use the same sequence for any item set on cash flow, balance sheet or non-GAAP quality.

  1. 1Read the question first, then find the exhibit with the reconciliation, cash flow statement or balance sheet notes.
  2. 2Identify what is reported and what the company adjusts or excludes. List each adjustment.
  3. 3Ask whether each adjustment is truly non-recurring. Costs that appear every year are recurring.
  4. 4Compute the check the question needs: CFO to net income, accruals ratio, or adjusted debt including off-balance-sheet items.
  5. 5Compare across years or with peers. Look at trend, not a single number.
  6. 6Decide the direction of quality: higher, lower or unchanged, and tie it to the evidence.
  7. 7Choose the option that matches your conclusion and reject options that overstate certainty.

Quickest way: Three-flag scan

When to use it: When time is short and the vignette is long.

  1. Flag 1: is CFO consistently below net income?
  2. Flag 2: do any adjustments exclude costs that recur, or add back real expenses?
  3. Flag 3: do liabilities or leverage sit outside the balance sheet, or do receivables and inventory grow faster than sales?
  4. If two or more flags are raised, lean to lower quality. If none, lean to higher quality.

Common mistakes in Non-GAAP Measures and Quality of Balance Sheet and Cash Flows

  • Treating every non-GAAP measure as misleading

    Students remember the warnings and forget the benefits.

    Fix: Judge by disclosure: clear reconciliation and genuinely one-off items support the measure.

  • Judging cash flow quality from one year

    One period of CFO below net income looks decisive.

    Fix: Look at a multi-year trend and the cause, such as a growth-driven working capital build.

  • Ignoring classification of cash flows

    Students focus on the totals.

    Fix: Check whether outflows are capitalised into investing or inflows such as factoring are pushed into CFO.

  • Forgetting to adjust leverage for off-balance-sheet obligations

    The balance sheet looks complete.

    Fix: Add guarantees, recourse liabilities and lease obligations where relevant before computing debt ratios.

  • Reading a lower accruals ratio as worse quality

    The direction is reversed.

    Fix: A higher accruals ratio means more earnings from accruals and lower quality.

Worked examples

Example 1

Vignette: Alder Co. reports net income of 80 and CFO of 50 for the year. Prior-year net income was 70 and CFO was 66. Receivables grew 30% while sales grew 8%. Q1: What does the CFO to net income ratio show? Q2: What does the receivables growth suggest?

Show the solution
  1. This year CFO ÷ NI = 50 ÷ 80 = 0.625.
  2. Prior year CFO ÷ NI = 66 ÷ 70 = 0.943.
  3. The ratio fell and is well below 1, so earnings are less backed by cash.
  4. Receivables grew much faster than sales, which suggests aggressive revenue recognition or weaker collection.

Answer: Q1: CFO to net income fell from about 0.94 to 0.63, indicating lower earnings quality. Q2: Receivables growing faster than sales is a warning sign of aggressive revenue recognition or collection problems.

Example 2

Vignette: Birch plc reports operating profit of 200. Its adjusted operating profit is 260 after adding back restructuring costs of 60. It has reported restructuring charges of 55, 58 and 60 in the last three years. Q1: Is the adjustment appropriate? Q2: What should an analyst use?

Show the solution
  1. Restructuring costs appear in each of the last three years at similar amounts.
  2. Costs that recur are part of normal operations, not non-recurring.
  3. So adding them back overstates sustainable profit.
  4. The analyst should use reported operating profit of 200, or deduct an average recurring charge.

Answer: Q1: No, the add-back is not appropriate because the costs recur every year. Q2: Use the reported 200, or treat restructuring as an ongoing cost, rather than the adjusted 260.

Exam tips

  • Always look for the reconciliation table in the exhibit and check each adjustment against whether it recurs.
  • Use the words of the answer options: 'lower quality' needs a cause, such as accruals, classification or recurring add-backs.
  • Remember IFRS allows choice in classifying interest and dividends, so adjust before comparing firms.
  • Do the arithmetic only when the question needs it; many items test judgment, not calculation.

Non-GAAP Measures and Quality of Balance Sheet and Cash Flows in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Non-GAAP Measures and Quality of Balance Sheet and Cash Flows: frequently asked questions

What is the difference between GAAP and non-GAAP earnings?

GAAP earnings follow the accounting standards in full. Non-GAAP earnings are management-defined and exclude or add items such as restructuring or share-based pay. Non-GAAP figures must be reconciled to the GAAP figure.

How do I assess cash flow statement quality?

Compare CFO with net income over several years, check that CFO comes from core operations, and look for classification shifts into investing or financing. A stable CFO close to or above net income is a good sign.

What are off-balance-sheet items?

They are obligations or assets not fully shown on the balance sheet, such as special purpose entities, guarantees, and receivables sold with recourse. Analysts adjust debt and ratios to include them where appropriate.

Are non-IFRS measures allowed?

Companies may disclose them, but regulators expect clear labels, reconciliation to reported measures and no undue prominence. Poor disclosure lowers the credibility of the measure.