Just what is Normalizing?
By: George D. Abraham
CEO & Chief Appraiser
Business Evaluation Systems
The International Glossary of Business Valuations Terms defines “Normalized Earnings” as “the economic benefits adjusted for non-recurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparisons.” There are very few industries where a company’s earnings will remain constant and therefore a business appraiser needs to “normalize” past earnings in order to accurately predict future income potential.
As closely held businesses are controlled by one or just a few individuals, the valuation analyst should consider whether the economic benefits being paid to its owners are above, below or at market levels. Sometimes the analyst can easily identify which items require normalization and at other times the analyst is left to his or her own analysis to identify the income normalization issues. These are adjustments that eliminate one-time gains or losses, other unusual items, non-recurring business elements, expenses of non-operating assets, and the like.
Examples of common items that are normalized in the valuation of a closely held business are:
- Related party rent. In many cases the owner personally owns the real estate and possibly machinery and equipment and leases them back to the company. The appraiser must determine if these leases are at fair market and adjust if it is not.
- Owner and related party compensation
Business owners will sometimes compensate themselves with the remaining profits left over after all other expenses have been paid. Here, the analyst must determine whether that compensation is at fair market level.
Other compensation can be to non working or overpaid relatives, which may include insurance, auto expenses cell phones, etc.
- Nonrecurring or extraordinary items such as nonrecurring legal fees associated with litigation, additions to expand the building the company operates from, hunting leases, costs associated with the owner’s boat and repairs from hurricanes or floods. Other nonrecurring items are lawsuit settlements, insurance proceeds, and changes in accounting methods, discontinued operations and gains or losses from the sale of assets.
- Non-Operating Assets. In many instances there may be assets that are not directly related to the production of earnings, such as the owner’s boat and Jeeps and tractors for the hunting lease. These assets would also be adjusted out of the balance sheet and in some cases excess cash.
- Discretionary Adjustments such as prerequisites, insurances, automobile, employee benefits, etc. Also, items that would normally be considered personal, but are nonetheless paid for through the business such as personal credit cards, owners home landscaping.
Some industries such as construction will have their workers build a new home for the owner or rental homes when business is slow. Another example is auto repair and body work companies where labor is working on the owner’s race car.
- Comparability Adjustments. The appraiser may adjust the subject company’s financial statements to facilitate a comparison between the subject company and other businesses in the same industry. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statements.
Internal Comparability adjustments may need to be made. Many times appraisers must annualize the current year using in-house financials. In many companies, the CPA adjusts the income and expenses on the in-house financials at the end of the year for tax purposes. Many times these adjustments relocate expenses (or income) to other areas of the financials so the appraiser must make sure that the current in-house financials categorize income and expenses the same as the 4 or 5 prior years prepared by the company’s CPA. Also the appraiser must account for seasonal differences whereby the remaining months may not reflect the same level of revenues, labor or inventory levels.
When the appraiser makes normalizing adjustments, certain clients and related parties may object. Valuation professionals generally should provide detailed explanations of their adjustments and,
whenever possible, support them with authoritative references, thus greatly minimizing potential confusion and arguments between the parties.