As we’ve discussed in a prior article, business valuations are performed for many reasons, including transactions, tax, and financial reporting. Regardless of the purpose, valuing a company is a complicated process with many gray areas. A popular misconception is that business value can be determined by simply reviewing a company’s income statement and balance sheet. As such, it’s common for the end-user of a business valuation to raise questions when the appraiser makes adjustments to the subject company’s financial statements.
These adjustments are part of the “normalization” process, which is a necessary step in accurately determining the value of a company. Normalizing adjustments alter a company’s historical financial statements so that they reflect its true operating performance and financial position. In the article below, we explain the basis for normalization and discuss some of the most common normalizing adjustments.
The Basis for Normalization
To perform an accurate business valuation, appraisers must have a clear understanding of the subject company’s true financial position and historical earning capacity. This information is needed to develop reasonable projections of a company’s future income-generating ability and assess its financial performance relative to industry peers, which is necessary to determine value under common valuation approaches.
Many business owners form their own opinions about the value of their companies based on financial statement information. While these documents are essential to the valuation analysis, it’s important to note that many privately held companies deviate from normal accounting practices and apply methods that make it difficult to create reliable comparisons. Additionally, financial statements often include expenses that may not reflect the company’s true operating performance. These expenses have a negative impact on the company’s earnings, and thus, its overall value. The purpose of normalization is to eliminate these types of anomalies and produce historical financial information that facilitates reliable forecasting and meaningful comparisons.
Examples of Normalizing Adjustments
Normalizing adjustments to the income statement are made for numerous reasons, but typically involve discretionary expenses, one-time gains or losses, other unusual or extraordinary items, discontinued business operations, and expenses or revenues related to non-operating assets. Adjustments to the balance sheet generally require adjusting certain assets and liabilities to reflect fair market value. Below are examples of the most common normalizing adjustments made by appraisers:
Owner Salary & Perquisites
Business owners have discretion over the amount of compensation they draw from their companies. Additionally, it’s common for owners to expense personal items (or “perks”) such as vehicles, cell phones, insurance, or travel and entertainment, through their company. A primary objective of many owners is to minimize their tax liability, so they sometimes draw above-market salaries or pass personal items off as business expenses to reduce their taxable income.
From a business valuation perspective, we must assume that a hypothetical buyer of a company would need to pay someone to take over the operational role of the current owner. This person would likely be compensated at the market rate that reflects his level of responsibility and industry norms. We must also assume that discretionary spending would not exist if the business were a reasonably well run, publicly traded company.
Therefore, appraisers often adjust income statements for discretionary expenses by adding them back to the company’s earnings. These add-backs include perks, as well as the difference between the owner’s actual salary and the appropriate market rate for compensation.
Sometimes a company pays above- or below-market rent to a related party, such as a holding company or a family member of the owner. In such cases, appraisers must adjust the rent to reflect fair market value. Often, a company doesn’t pay rent because it owns the real estate on which it operates. Alternatively, the company may own facilities that it rents to a third party. If the company’s real estate is not an integral part of operations, it is a non-operating asset and should be treated as separate from the company’s operations and removed from the balance sheet, along with any loans on the real estate.
In such cases, the appraiser must assume that a hypothetical buyer would rent its facilities from an unrelated party. If the company occupies the facilities, a rent expense that reflects prevailing market rental rates should be added to the income statement. On the other hand, if the company rents the facilities to a third party, any rental income it generates should be removed. Earnings should also be adjusted to remove any depreciation associated with the real estate.
Extraordinary or Non-recurring Items
A company may receive income or incur an expense as the result of an event that is abnormal, unrelated to the company’s ordinary day-to-day operations, or unlikely to reoccur in the foreseeable future. These items are often referred to as one-time, extraordinary, or unusual gains/losses, and are often a result of events such as the following:
- Discontinued business operations
- Natural disasters
- Restructuring charges
- One-time repairs/renovations
- Insurance payouts
- Abnormal expenses
- Gains/losses on the sale of assets
Keeping these items on an income statement distorts a company’s true earning capacity and reduces value. Appraisers review financial statements and interview management of the subject company to identify these types of items before adjusting for them. Non-recurring expenses are added back to the company’s earnings while non-recurring gains/revenues are removed.
Accounting Methods for Inventory and Depreciation
Some private companies may account for inventory using the “last-in, first-out” (LIFO) method for the tax benefits it confers during periods of inflation. Inventory purchased more recently is typically more expensive, which raises cost of goods sold and reduces taxable income.
Under the “first-in, first-out” (FIFO) method, inventory is typically higher and more reflective of fair market value because the most recently purchased and higher cost inventory remains on the balance sheet. Therefore, appraisers sometimes make adjustments from LIFO to FIFO, which is typically accomplished by adding the LIFO reserve back to inventory on the balance sheet. Adjustments to the income statement are also made by subtracting the yearly change in the LIFO reserve from the cost of goods sold.
Some companies also use an accelerated depreciation method, which results in a higher depreciation expense over the early life of an asset. This provides tax benefits as it reduces taxable income. Straight-line depreciation allocates the costs of assets evenly over their useful lives, and as a result, often provides a better indication of the fair market value of assets.
Appraisers must determine which depreciation method and useful life to use based on norms within the subject company’s industry. If the appraiser determines that the company’s depreciation methods deviate from industry norms, he or she must adjust asset values and depreciation expense based on the method that should be applied. Occasionally, certain fixed assets may require an appraisal and corresponding adjustments may be necessary.
Reading between the Lines
Many owners do not consider how the items above may produce a distorted view of a company’s value. Before making important strategic decisions that impact your company, make sure that your actions are being guided by clear and accurate financial information. Owners should be particularly concerned about the quality of their financial information if they plan on selling their company in the near future.
Prospective buyers are interested in the benefit stream that a company is expected to generate into the future. During the sale process, they scrutinize a company’s past financial performance to gain a better understanding of its true financial performance. If prospective buyers have to analyze a significant amount of normalizing adjustments, it will be more difficult for them to see the company’s true earning potential. As a result, they may not be willing to pay as much for the company. Therefore, it’s important for owners to start eliminating discretionary expenses and other items that necessitate normalizing adjustments several years before they plan to sell.
This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.