What Does It Mean To Normalize Financial Statements?
By Chad Bell, Senior, Advisory Services
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 financial statements should be normalized: (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 of time 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 financials, trends, and financial ratios to other companies within the same industry provides the analyst with a qualitative element 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:
- Unusual, nonrecurring or extraordinary items;
- Non-operating items;
- Accounting differences (accounting differences are outside the scope of this article); and
- Discretionary items.
Nonrecurring, non-operating, and accounting differences do not consider whether the subject interest has financial control. Discretionary items, on the other hand, do consider if the subject interest has financial control. A discussion of each normalizing adjustment is found below:
Unusual, Nonrecurring or Extraordinary Items
According to Accounting Principles Board (APB) Opinion No. 30, by definition an extraordinary item must be (i) unusual in nature and (ii) infrequent in occurrence. If an item meets both of these 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. Clearly, if the analyst does not properly adjust for the financial 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.
Then again, there are often unusual, nonrecurring, or extraordinary items that do not meet the criteria under APB No. 30. These include, but are not limited to:
- The gain or loss on the sale of assets;
- Insurance proceeds from life insurance or another claim;
- Significant investment in a new facility to expand operations; or
- Settlement proceeds or expenses related to a lawsuit.
The above items may be unusual in nature but occur more frequently than permitted by APB No. 30. It is up to the analyst to consider the nature and likelihood of recurrence in determining whether the item should be normalized out or retained in the company’s results. For example, if the subject company has a gain (or loss) on the sale of assets in four of the past five years, and after discussing it with management, the analyst understands this practice will continue, then the income (or expense) related to the sale of assets may not be normalized out.
Unfortunately, some brokers and appraisers take this concept too far and remove all questionable expenses without discussing these items with management or considering their nature or the frequency of recurrence. Going back to the previous example, if the income (or expense) associated with the sale of assets was removed, it could skew the results. As such, a healthy dose of realism should be injected into this process.
Separate from nonrecurring items are non-operating items. Non-operating items are not directly 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.
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 of time into the future.
There is a school of thought that considers the need to adjust discretionary items, even if the subject interest does not have control prerogatives to implement such changes (i.e., a minority interest valuation). The rationale is to put the subject company on an “apples-to-apples” basis with other guideline companies or more accurately reflect the earning stream available to a hypothetical financial buyer of the company. In essence, a minority interest valuation is performed as if the minority shareholder had financial control. If this approach is taken, a discount for lack of control is applied at the end of the valuation.
Another common school of thought is that the buyer may have no ability to control or change discretionary items, and therefore, no discretionary adjustments should be made, and no discount for lack of control should be applied at the end of the valuation.
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, though salaries are subject to IRS scrutiny. 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 reasonably expect to pay an individual filling whatever capacity the old 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.