A business may be valued for a multitude of reasons, like marital dissolution, estate planning and mergers and acquisitions, among others. No matter a valuation’s purpose, one of the most critical steps during analysis is considering various normalization adjustments to the business’s financial statements.
Normalization adjustments are made to a company’s financial statements in an effort to make them comparable to similar companies in the subject’s industry. The adjustments are a crucial step in valuing a business at fair market value.
According to the International Valuation Glossary, fair market value is defined as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Without making these normalization adjustments, a company’s value may be severely overstated or understated from its true fair market value.
Essentially, we want to arrive at normalized earnings that reflect an interest that would show aspects of control over expenses and income streams, and operate as a company similar to others in the same industry.
Normalization adjustments can be categorized into three standard adjustments: general, nonrecurring and nonoperating adjustments.
General adjustments are made to income and expenses that are normal throughout the course of business, but may not be reflective of industry standards. Some common normalization adjustments include normalizing officers’ compensation, removing unusual gains or losses outside of what is normal for the subject’s industry, and standardizing depreciation methods.
Nonrecurring adjustments are made for income and expenses that are not expected to occur again. These can include gains and losses from the sale of assets, income from Covid-related PPP and SBA loans that have been forgiven, and abnormal legal costs.
Nonoperating adjustments are adjustments for income and expenses that are not directly related to the business operations of a company. These can include travel for a family vacation of one of the owners, expenses related to the owner’s vehicle and vacation property, and meals and entertainment.
The best way to understand the effect of normalization adjustments is through an example. Take a look at the scenario below. Let’s assume we are valuing a small consulting company. For simplicity, we’ll make three common normalization adjustments:
As seen above, after we made normalization adjustments, net income decreased by $175,000. After we subtract taxes and divide by a 20% capitalization rate, the difference between the unadjusted and normalized indicated equity values is $634,000.
In short, normalization adjustments are a critical step in achieving an accurate valuation of a business. They allow the appraiser to better express and understand the true financial position of a business.
Failure to understand and make these normalization adjustments can lead to a valuation that overstates or understates value. An experienced valuation professional is able to identify these types of adjustments and how to incorporate them into the analysis.
Our Forensic, Valuation & Litigation Support Group can help. Contact us online or call us at 800.899.4623.