Adjusted operating income

What Is Adjusted Operating Income?

Adjusted operating income is a non-Generally Accepted Accounting Principles (non-GAAP) financial metric that modifies a company's reported operating income to exclude specific items that management deems non-recurring, unusual, or unrelated to the company's core business operations. This measure falls under the broader category of Financial Reporting and Analysis. The purpose of presenting adjusted operating income is to provide a clearer view of a company's ongoing profitability from its primary activities, separating out the impact of events that are considered one-off or peripheral. While not standardized by accounting bodies, adjusted operating income is frequently used in corporate financial disclosures to supplement official financial statements.

History and Origin

The concept of "adjusted" financial metrics, including adjusted operating income, gained prominence as companies sought to provide investors with a perspective on their underlying business performance, often arguing that GAAP numbers could obscure this view due to specific accounting treatments or extraordinary events. This practice became more widespread, leading to increased scrutiny from regulators. The U.S. Securities and Exchange Commission (SEC) has historically provided guidance and interpretations on the use of non-GAAP measures, aiming to ensure they are not misleading to investors. This regulatory oversight, which has been updated over the years, emphasizes that companies must clearly reconcile non-GAAP figures to their most directly comparable Generally Accepted Accounting Principles (GAAP) counterparts and explain why management believes these adjusted measures are useful.⁶

Key Takeaways

• Adjusted operating income removes certain expenses or revenues from reported operating income that management considers non-recurring or non-operational.
• It is a non-GAAP financial measure intended to highlight a company's sustainable core business performance.
• Common adjustments can include restructuring charges, impairment losses, gains or losses from asset sales, and legal settlements.
• While providing an alternative view, investors should compare adjusted operating income with GAAP operating income and understand the nature of the adjustments.
• It is used in financial analysis and valuation to assess a company's operational efficiency and earnings power.

Formula and Calculation

Adjusted operating income is derived by taking the reported operating income from a company's income statement and adding back or subtracting specific items. The specific formula can vary based on the nature of the adjustments a company chooses to make, but it generally follows this structure:

Where:

• Operating Income: The profit a company makes from its core operations before deducting interest and taxes.
• Non-Recurring/Non-Operating Adjustments: These are items that management identifies as unusual, infrequent, or not indicative of the company's ongoing operational performance. Examples include one-time legal settlements, asset impairment charges, gains or losses from the sale of non-core assets, or significant restructuring charges.

For example, if a company incurs a large, one-time legal expense, it might add that expense back to its operating income to arrive at adjusted operating income, arguing that this expense is not part of its typical operating costs. Conversely, if there's a one-time gain from selling a property, that gain might be subtracted.

Interpreting the Adjusted Operating Income

Interpreting adjusted operating income requires careful consideration. Proponents argue that it offers a clearer picture of the operational health and underlying earning power of a business by filtering out volatility from exceptional items or non-operational activities. For example, a company might use adjusted operating income to showcase improved performance when a large, one-time charge under GAAP would otherwise obscure positive trends in its core business.

However, users of financial information must critically evaluate the nature of the adjustments. It is important to ascertain whether the excluded items are truly non-recurring or if they represent expenses that are, in fact, part of the ordinary course of business over a longer period. Comparing adjusted operating income across different companies can be challenging because there is no standardized definition for what constitutes an "adjustment." Investors often look at this metric in conjunction with other key performance indicators and traditional GAAP measures like net income.

Hypothetical Example

Consider Tech Innovations Inc., a publicly traded software company. For the fiscal year, Tech Innovations reports the following:

• Operating Income (GAAP): $50 million
• One-time restructuring charge related to office consolidation: $10 million
• Gain on sale of an old non-core patent: $3 million

To calculate its adjusted operating income, Tech Innovations' management would add back the restructuring charge and subtract the gain from the patent sale:

In this scenario, Tech Innovations' adjusted operating income of $57 million is presented alongside its GAAP operating income of $50 million. The company might argue that the $57 million figure better represents the ongoing profitability of its software development and sales, as the restructuring charges and patent sale are not part of its regular operations. This allows investors to focus on the performance of the underlying core business.

Practical Applications

Adjusted operating income is commonly used in several areas of finance and business:

• Corporate Financial Reporting: Many public companies report adjusted operating income and other non-GAAP metrics in their earnings releases and investor relations materials. For example, Thomson Reuters has reported "adjusted earnings" that exclude "one-off costs and exceptional items" in their financial results.⁵ This is done to provide a perspective on performance that management believes is more reflective of ongoing operations.
• Performance Evaluation: Analysts and management often use adjusted operating income to assess the underlying operational efficiency and financial health of a company. It can facilitate year-over-year comparisons by removing the distorting effects of unusual events.
• Mergers and Acquisitions (M&A): In M&A due diligence, adjusted operating income can be used to normalize the earnings of target companies, making them more comparable to potential acquirers or industry benchmarks. This helps in deriving a more accurate valuation.
• Compensation Schemes: Executive compensation plans may tie bonuses or incentives to adjusted operating income targets, incentivizing management to focus on operational improvements distinct from extraordinary financial events.
• Credit Analysis: Lenders and credit rating agencies may consider adjusted operating income to gauge a company's ability to generate cash flow from its regular operations to service debt.
• Government Tax Calculation: While not directly "adjusted operating income," government bodies also define "adjusted income" for various purposes. For instance, the New York State Department of Taxation and Finance refers to "Adjusted Gross Income" for determining eligibility for tax refund checks, illustrating how adjustments to reported income are used for specific, official calculations.⁴

Limitations and Criticisms

While adjusted operating income can offer insights into a company's ongoing performance, it has notable limitations and faces significant criticism.

• Lack of Standardization: Unlike GAAP, there are no universally accepted rules for calculating adjusted operating income. This lack of standardization means that companies can choose which items to exclude, potentially making it difficult to compare performance between different companies or even for the same company across different periods if the adjustments change.
• Potential for Misleading Information: Critics argue that companies may selectively exclude recurring operational expenses or "manage earnings" to present a more favorable financial picture. Regulators, such as the SEC, monitor non-GAAP disclosures closely to prevent measures that could be misleading, particularly those that exclude normal, recurring cash operating expenses necessary for the business.³ This highlights the tension between management's desire to present a "clean" operational view and the need for transparent, comprehensive financial reporting.
• Exclusion of Real Costs: Some "non-recurring" items, such as restructuring charges or impairment losses, can be a regular feature of a company's lifecycle, especially in dynamic industries. Consistently excluding such costs might overstate the true operational profitability and lead to an unrealistic assessment of risk.
• Impact on Earnings Per Share (EPS): When adjusted operating income is higher than GAAP operating income, it can lead to higher adjusted earnings per share (EPS), which might influence investor perception without fully reflecting all costs incurred.
• Reconciliation Requirement: To mitigate some of these concerns, the SEC requires companies to present the most directly comparable GAAP measure with equal or greater prominence and provide a clear reconciliation between the non-GAAP measure and the GAAP measure.² However, the sheer volume and complexity of adjustments can still challenge effective financial analysis.

Adjusted Operating Income vs. Operating Income

The primary distinction between adjusted operating income and operating income lies in the scope of what is included or excluded.

While operating income offers a standardized and audited view of a company's direct profitability from its main business activities, adjusted operating income is a management-defined metric used to highlight what the company considers its "true" operational earnings, free from items they deem extraneous. Investors and analysts often consider both metrics to gain a comprehensive understanding of a company's financial health. Other profitability metrics like EBITDA also serve similar purposes of providing alternative views of earnings.

FAQs

Why do companies report adjusted operating income?

Companies often report adjusted operating income to provide investors and analysts with a clearer picture of their ongoing, "run-rate" profitability from their core operations. Management believes that by removing the impact of one-time or unusual events, this metric better reflects the sustainable earnings power of the business and helps in financial analysis.

Is adjusted operating income more reliable than GAAP operating income?

Neither is inherently "more" reliable; they serve different purposes. GAAP operating income is standardized, audited, and follows strict accounting principles, ensuring comparability. Adjusted operating income is a supplementary metric that offers management's perspective on underlying performance, but it lacks standardization and can be subjective. It's best to consider both for a complete understanding.

What kinds of adjustments are typically made to calculate adjusted operating income?

Common adjustments include adding back non-cash expenses like asset impairment charges, depreciation, and amortization (though often for EBITDA, not just operating income), or one-time cash expenses like large legal settlements, restructuring charges, or acquisition-related costs. Conversely, non-operating gains (e.g., from asset sales) might be subtracted.

Does the SEC regulate adjusted operating income?

Yes, the SEC provides guidance on the use of non-GAAP measures, including adjusted operating income. While it does not define how to calculate them, it requires companies to reconcile these measures to the most directly comparable GAAP measure, explain their usefulness, and ensure they are not misleading.¹ The SEC aims to prevent companies from presenting non-GAAP measures that obscure or misrepresent their financial performance.