What is normal? A question we seem to have been asking ourselves for the last few years. When it comes to making sense of the “normal” in this new day and age, we cannot offer any advice there. But we can speak on the process and importance of normalizing financial statements for a business valuation.
It is common for a business valuator to make adjustments to reported financial statements to more accurately reflect ongoing, operating cash flows of a business. These adjustments are part of the “normalization” process, with an ultimate goal of determining the earnings capacity of the business.
In litigation, when two financial experts’ valuation reports are compared, both the adjustments deemed necessary, and the dollar amount attributed to each can be a factor in the differences in valuation conclusions.
To perform an accurate business valuation, appraisers must have a clear understanding of the subject company’s true financial position and historical earnings capacity. This knowledge is vital to comprehend the company’s future income-generating ability and assess its financial performance relative to industry peers as well as its own historical performance.
Valuators obtain multiple years of financial statements (typically 5 years), most commonly the income statement and balance sheet. These statements should be analyzed thoroughly to evaluate historical operating results and the conditions under which they were achieved, accounting methods, etc. This is generally the first step in the normalization process: holistically understanding the normal operating conditions of a company in context of itself, its industry, and the grander economy, to in turn understand if any conditions are potentially present for normalizations.
Reviewing historical trends of the subject business and its peers, comparing current financial results to prior year(s), utilizing ratio and margin analysis, as well as historical common-sized statements, are all examples of procedures to examine where potential adjustments could exist. Only once the appraiser has completed the due diligence required to understand the nature of a company’s operations and the industry in which it operates, can relevant and appropriate informed adjustments be made.
While adjustments can come in many shapes and sizes, we have selected a few common and/or recent types of adjustments that we regularly encounter.
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.
As we discussed earlier, a thorough understanding of what the business does operationally on a day-to-day basis can pinpoint if an expenditure can be classified as non-recurring or a regular business expense. These items are often referred to as nonrecurring, extraordinary, or unusual gains/losses often the result of events such as:
The objective of adjusting for unusual, extraordinary, and nonrecurring items is to present the financial results associated with normal operating conditions that can be indicative of future operating performance. Additionally, these adjustments enhance comparability among the subject company and guideline public companies, i.e., provide a ‘public equivalent.’
Privately held business owners may have discretion over the amount and type of compensation they receive, as well as perquisites paid for by the business such as vehicles, cell phones, travel, meals, insurance, etc. The goal is to understand the total compensation paid to management and the business owner(s) and for what roles and responsibilities.
From a business valuation perspective, we assume that a hypothetical buyer of subject company would need to pay market rates to replace subject management and/or owner(s). A review of historical salary trends for all owners, investigating potential deferral of bonus or payroll, as well as evaluating professional resources to examine the specific industry owner’s estimated compensation, is vital to determine if an adjustment is necessary.
A company may pay above or below-market rent to a related party, such as a holding company or a family member that owns the property. In this case, an appraiser may normalize rent expense to related parties by adjusting the rent expense to market rate for similar properties. By adjusting the rent to market rates, the financial statements are adjusted to be representative of a normal condition of the subject company as of the business valuation date.
In an alternative hypothetical scenario, the company may own facilities that it rents to a third party. If the company’s real estate is not related to the core operations of a business, it is a non-operating asset and should be treated as separate from the company’s operations, removed from the balance sheet, along with any loans associated on the real estate. Also, rental income and further related expenses would be removed.
Fact Pattern #1: Manufacturing company has a plant fire that destroys the factory. The company did own an insurance policy covering part of the costs to repair the plant. Any reported loss resulting from the extraordinary event, and the income recognized from the insurance payout should be normalized. Additionally, adjustments to cash may be necessary representing unusual, one-time insurance proceeds.
Fact Pattern #2: Car dealership has an investment in an unrelated company. Although the investment may provide an income stream, this income typically would not be considered to represent the company’s normal operations. As a result, the income stream could be reasonably removed, as would the asset from the book value. Following this potential methodology, this investment would be added as a non-operating asset to the estimated operating value of the subject company for an adjusted value.
Fact Pattern #3: Manufacturing company incurs significant expense to update equipment. In this example, the business cycle must also be considered. During the analysis of the industry and its corresponding business cycle, the expert finds it is common for a manufacturing company to update its productive equipment every five years. Thus, these updates could be “normal” capital maintenance or investment, and would, therefore, not need to be adjusted or excluded. Alternatively, the appraiser could ‘smooth’ out the expense, meaning removing the hit from the single year and add an average expense for the five-year period analyzed.
This is an example where the appraiser must understand the accounting used by the company – have they depreciated the full expense in Year 1? Or have they used straight-line depreciation? There are variations from company to company and this is but one of the many factors a valuator reviews during due diligence.
Normalizing financial statements is a component of the valuation process. Further, this tends to be one of the more common areas where experts may disagree.
Adjusting for significant revenue or expense items that appear to be related to the operating interests of a company requires the informed judgment of a financial expert. A competent and qualified valuation expert is necessary to the process to diligently examine the historical financial statements and further information to understand the true nature of the company’s operations.