The Role of Normalization Adjustments in Business Valuation by Sharon Foote, ASA, CFE
Posted on September 20, 2015
The income approach is one of the most commonly used and generally accepted methods to determine the value of a business interest. This approach quantifies the net present value of future benefits associated with ownership of a business interest which are then discounted or capitalized at a rate appropriate for the associated risk. The capitalization of cash flows method and the discounted cash flow method are included in the income approach. In applying a market approach, market multiples obtained from an analysis of guideline companies or market transactions are often applied to revenue and earnings data to determine value.
An important step in using the income approach or the market approach is to go through the process of normalizing the financial statements. Normalized financial statements are defined in the International Glossary of Business Valuation Terms as “financial statements adjusted for non-operating assets and liabilities and/or for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparison”. The goal of the normalization process is to estimate future expected cash flow that a potential buyer can reasonably expect to receive in return for his (or her) investment and to present information that is on a basis similar to that of other companies in its peer group and in benchmark studies used for comparison and analysis.
There are various categories of normalization adjustments that can be made, which may be applicable to a particular set of facts and circumstances. The adjustments that can be made to the income statement generally fall into the following categories:
- Ownership Characteristics (controlling vs. non-controlling interest),
- GAAP Departures (Generally Accepted Accounting Principles),
- Extraordinary or Nonrecurring Income or Expenses, and/or
- Income and Expenses related to Non-operating Assets or Liabilities.
A shareholder owning a controlling interest in a business entity can make control adjustments, whereas a non-controlling (or minority) shareholder would not be able to force those changes. Control adjustments that could be made to reflect the cash flow available to a potential buyer include the following, for example:
- Excess (or deficient) officers’ compensation, benefits (such as health insurance and retirement contributions) and perquisites (such as luxury cars, country club memberships, and the like),
- Excess or below-market rent paid to shareholders or related entities,
- Personal travel and entertainment of shareholders and management,
- Excess intercompany fees and payments to a related entity with common ownership,
- Changes in the capital structure of the entity.
GAAP departures are in the second category. The most common GAAP adjustment is for entities reporting their financial statements on a cash basis. GAAP requires accrual basis accounting; therefore, properly recording unrecorded assets and liabilities to the entity’s financial statements is needed.
The effect of extraordinary and nonrecurring items should also be removed from the income statement since they affect the valuator’s estimate of a normal level of future cash flows. Some common examples of this type of normalization adjustment are:
- Gains or losses on the sale of business assets,
- Extraordinary one-time casualty expenses, e.g., a hurricane or other casualty (over the amount of any insurance recovery),
- The costs of litigation expenses, payments or recoveries.
Adjustments for income and expenses related to non-operating assets and liabilities are also removed to obtain a normalized level of future cash flows. For example, if a manufacturing company is holding a piece of vacant land as an investment, this would be a non-operating asset; the related real property tax would be a non-operating expense and should be removed from the income statement for normalization purposes. If there is a loan on that investment property, this would be a non-operating liability, and the related interest expense should be removed from the income statement as well.
Going through the normalization process will result in the valuator constructing a normalized income statement that will better reflect the true economic income of the subject business, allowing for a better comparison of the subject company’s financial performance to similar companies or its industry peer group. More importantly, this exercise will produce a level of future economic benefits that can be utilized in determining a reasonable value of the business interest.
Examining a company’s financial statements to determine the appropriate adjustments to be made is best left to the judgment of an experienced business valuation analyst after discussions with management.
About the author: Sharon Foote is a manager in the Forensics and Business Valuation practice in Berkowitz Pollack Brant’s Miami office. For more information, call (305) 379-5598 or email firstname.lastname@example.org.