WHAT DOES IT MEAN TO NORMALIZE FINANCIAL STATEMENTS?

In every valuation, the analyst must evaluate the historical financial statements for any items that needs to be adjusted, or normalized, from the financial statements. This analysis is a critical step that has significant impact on the valuation conclusion. There are two reasons why a company’s normalized income statement matters: (i) to provide a basis of comparison to other industry participants, and (ii) for arriving at an appropriate earnings stream to discount, capitalize, or apply a valuation multiple to.

The goal of normalizing historical financial statements is to determine a level of earnings that an arms-length, hypothetical financial buyer would be able to anticipate from the business for some period into the future. It removes not only one-time or extraordinary income and expenses, but also adjusts for accounting anomalies as well as owner perquisites that are so common in a closely held business.

Comparing the normalized financial statements, trends, and financial ratios to other companies within the same industry provides the analyst with qualitative elements that can be used in evaluating the risk related to the subject company as compared to other industry participants. The perceived risk level of the company is taken into consideration, along with other quantitative and qualitative factors, in determining the appropriate capital rate, discount rate, or valuation multiple to apply.

Normalization adjustments are meant to remove items appearing in the subject company’s financial statements that are either unlikely to be repeated in the future or are unrelated to the company’s business operations. 

NORMALIZING ADJUSTMENTS INCLUDE:

1. Unusual, nonrecurring, or extraordinary items. an extraordinary item must be (i) unusual in nature and (ii) infrequent in occurrence. If an item meets both criteria, the related income or expense should be normalized out of the company’s reported results because it is not truly representative of the subject company’s earning power or expense structure. An example of this would be a catastrophic event which would severely limit or stop a company’s operations. If the analyst does not properly adjust for the fiscal impact caused by such catastrophic event, then the valuation is significantly flawed because it includes lower revenues or higher expenses which are not expected to occur again in the future.

2. Non-operating items. Separate from nonrecurring items are non-operating items. Non-operating items are not related to a company’s business operations, regardless of their frequency. For example, if a company has enough excess cash that it begins investing in marketable securities, any income related to those marketable securities is a result of excess cash, not a result of business operations. As such, any income (or expense) related to the company’s marketable securities should be removed, as it distorts the company’s earnings from its business operations. In some instances, non-operating items are valued separately and added to or subtracted from the valuation conclusion.

3. Discretionary items. Discretionary items may need to be adjusted out if an owner of a privately held business takes benefits beyond “fair market value” compensation from the company. Again, the goal of normalizing historical financials is to derive a level of earnings that a hypothetical financial buyer could expect from the business for some period into the future.

Common examples of discretionary items include:

Owner compensation and perquisites: in privately held companies, owners have some discretion to pay themselves salaries they think are appropriate. These payments may or may not be at market rates or include other perquisites that are not commensurate with the compensation structure of the position in question. The goal of these types of adjustments is to restate owner salaries to the level at which a new owner could expect to pay an individual filling whatever capacity the former owner filled.

Related-party transactions: many small business owners own not just one, but two or more businesses, some of which transact business together. In these cases, the prices paid for goods or services among the companies are often below market rates. The rates currently charged between related companies could be the result of an estate planning strategy or an effort to minimize taxes. The analyst needs to carefully assess the true economic value of such transactions, and state them at an arm’s-length price.

Personal use of assets, such as vehicles: many small business owners have assets in the company that are available for their personal use. A careful consideration of how the asset is being used, who is using it, and for what purpose should be considered when treating them as non-operating assets.

Personal expenses charged through the business: additionally, many small business owners will charge personal expenses to the business as a “perk” of being an owner. This might include charging the home utility bill to the business, paying a family member a wage for limited services, egregious or overstated travel budgets, or home real estate taxes being charged as taxes related to the business. These expenses should also be treated as non-operating expenses of the business and any financial statement impact removed.

Expenses charged that are unrelated to the business operations: some expenses, such as charitable contributions, are irrelevant to a company’s ability to operate. In some cases, charitable contributions could be viewed as a type of marketing, in which case, an argument can be made that the expense is necessary. Regardless, the analyst must ask management how expenses are used and for what purpose, to gain an understanding of adjustments that should be made.

It often takes a discussion with management and viewing the financials through a forensic lens to uncover these expenses and where they are hidden. For example, it may not stand out to the analyst that an owner is using a company vehicle for personal use unless the question is posed. In some cases, going through the income statement line by line, tracking credit card statement items, or conducting a detailed analysis of the general ledgers is necessary to understand what lies behind the numbers.

Failure to appropriately consider each of these areas of potential financial statement adjustment can result in a significantly flawed valuation conclusion. If you have questions about EBITDA adjustments for your business, it is a good idea to seek expert guidance. Our team has access to valuable resources to help you understand and navigate this metric.

Book an initial (no obligation) Consult

ABOUT THE SHAUGHNESSY GROUP

Established in 2017, the Shaughnessy Group helps business owners sell or divest their lower middle-market, privately held businesses. In addition to this, the Shaughnessy Group also assists clients in growing their businesses through acquisitions and securing debt funding for those acquisitions. With a focus on providing expert guidance and support, the Shaughnessy Group helps business owners navigate the complexities of selling or acquiring a business. To learn more, visit www.shaughnessy.group.

ABOUT THE AUTHOR

Karl Sigerist is a business advisor who helps shareholders, board members, owners, entrepreneurs, and executives navigate issues related to governance, strategic planning, and corporate finance throughout the life cycle of their business. He has experience in starting up eight organizations in the public and private sectors, as well as leading three turnarounds of Canadian and European private and public organizations. Karl has successfully led the growth of several business-to-business technology, specialty finance, warranty, and creditor insurance companies through mergers, acquisitions, strategic alliances, and capital raises, resulting in the development of leading national brands and platforms. He has also fostered cultures and teams that have achieved Growth 500 status for five consecutive years and been recognized as a Top 100 Small & Medium Enterprise Employer for two consecutive years. In addition to his professional work, Karl serves as a mentor to business school students and newly immigrated Canadians, and volunteers on not-for-profit boards. You can find out more about Karl on his LinkedIn profile at https://www.linkedin.com/in/karlsigeristjr/.

Seeking the Latest Insights? 

Subscribe to our newsletters, register for upcoming events, download free content from our library of resources below.