Normalizing adjustments relate to non-recurring or unusual items of income or expense that occur on the income statements of companies. They also relate to discretionary items of income or expense (usually expense) that occur for or for the benefit of owners of businesses. We addressed these two categories of normalizing adjustments in a previous post.
There are other types of normalizing adjustments that occur because of the relationship between the balance sheet and the income statement. The process of normalizing a company’s balance sheet may give rise to additional normalizing adjustments for the income statement. In this post we address additional questions and issues about normalizing adjustments and then discuss balance sheet adjustments.
Non-Operating Items on the Balance Sheet Give Rise to Normalizing Adjustments
Non-operating, excess or redundant assets on a company’s balance sheet can also give rise to normalizing adjustments on the income statement. Appraisers should consider appropriate adjustments for the income or expenses associated with every non-operating asset. Non-operating assets include many possibilities:
- Cash value of life insurance. It may be appropriate to normalize earnings for the cost of the insurance.
- Farmland or other excess real estate. It would be appropriate to adjust earnings for all expenses associated with such assets.
- Excess cash or portfolios of marketable securities. In the current low interest rate environment, cash does not earn much, but adjustments should be made for earnings on it. Similarly, dividend income and gains or losses on a portfolio of securities should be adjusted out of the normalized income statement.
- Vacation homes at a beach or in the mountains. Expenses associated with this type of asset include depreciation, taxes and other expenses associated with owning homes.
- Artwork. There may not be significant costs associated with art, unless the purchase price is being amortized.
- Other non–operating assets. There are quite unusual things on the balance sheets of some companies.
I always ask about non-operating assets because they may or may not be on a company’s balance sheet. I recall valuing a company that made dentures back in the 1980s. It turned out that they had gold filings in a safe that had been accumulated as they worked on dentures. That gold was worth more than the entire company!
Non-operating assets should be eliminated from a company’s balance sheet for valuation purposes. At the conclusion of the valuation, which will be based on normalized earnings as discussed above, the non-operating assets will be added to value, perhaps after considering appropriate tax consequences.
It is important to understand that for nearly every balance sheet adjustment, it is appropriate to consider if there is a corresponding normalizing adjustment for the income statement.
Identification of Normalizing Adjustments
There are a number of ways that business appraisers and market participants identify potential normalizing adjustments. These include:
- Financial spreadsheet analysis. Spreading the financial statements for the past several years in a consistent format, including the income statement, the balance sheet, detailed expense schedules, revenue by product or category and so on. When figures on a line item of the income statement or balnce sheet move significantly from one period to the next, it is possible that a normalizing adjustment of some kind might be needed. The appraiser will ask you what happened to make that determination.
- Cash flow statement analysis. The statement of cash flows, if available in your audit of other financial statements, will sometimes include noncash charges, like write-downs of goodwill items.
- Reviewing the audit. Business appraisers and market participants will carefully read the notes to the audited or reviewed financial statements to identify items that might require adjustment. For example, if a company acquired a division of another company at the end of the third quarter, and the new acquisition generated sales of $750 thousand and operating income of $150 thousand in the fourth quarter, a business appraiser would likely normalize that acquisition to give full effect for a year’s sales and earnings. If you had made that acquisition, you would definitely want any potential acquirer to make a similar adjustment! That is just one example, but reviewing the audits is an important element of valuation analysis.
- Comparisons with peer groups. Sometimes, potential adjustments can be identified by examining comparable ratios for peer groups. Outlier ratios are the subject of further investigation.
- Inquiring of management. Sometimes the only way to identify a normalizing adjustment is to ask management. For example, in a potential sale, an owner would want potential buyers to normalize earnings for the salary paid to his non-working girlfriend. And he might offer that information. The only way a business appraiser will identify adjustments like these is to ask.
It takes analysis and inquiry to identify appropriate normalizing adjustments. Don’t be surprised when your business appraiser asks lots of pointed questions. He needs to identify appropriate normalizing adjustments so that his valuation will be reasonable.
Recurring or Not?
There can be differences of opinion regarding whether income statement items are recurring or not. In a transaction environment, differences of opinion may relate to the impact of specific adjustments on adjusted earnings. If you are selling, it is in your best interest for an expense item to be considered nonrecurring and added to normalized earnings. If a market participant is buying, the opposite logic holds.
I’ve seen business appraisals where the appraisers made many adjustments in each year of the analysis. The problem with this is that what may, on the one hand, seem to be unusual or non-recurring, may not actually be so. There is a randomness to business, such that one year’s potential non-recurring item is offset by another of a similar amount the next year, and so on.
One way that appraisers and buyers check on the reasonableness of proposed normalizing adjustments is by checking the implied earnings margins that result from the adjustments. For example, if an appraiser “normalized” earnings to an 18.0% EBITDA margin for a company in an industry where EBITDA margins tended to run in 8% to 10% range, something would clearly be wrong. The result of such a normalization process is simply not believable.
There are some unscrupulous firms that sell very expensive “valuations,” ostensibly to prepare companies for sale. They sometimes “recast” earnings in such a fashion that no buyers will believe them. These firms make excessive and unrealistic normalizing adjustments and create false expectations of value in the minds of business owners.
When their companies do not sell, the owners are left with very expensive and useless valuations in their files, disappointment, and unrealistic thoughts about the values of their businesses. Consider this a warning. If approached by someone selling an expensive valuation and offering to “recast” your earnings, investigate whom you are talking to and be ready to run the other way.
I am not suggesting that anyone who talks about normalizing your income statement is unscrupulous. I’m doing that here and I certainly don’t think I fit in that category. However, be sure you understand the real purpose of any valuation engagement and the qualifications and experience of any appraiser or industry expert you may consider retaining. More on this topic later.
I’ve often said that business life is full of one non-recurring event after another. Normalizing adjustments are important tools for business appraisers and for business buyers. Your business appraiser will likely not adjust for everything you might think is non-recurring and your potential buyers almost certainly will not make all the adjustments. There is a natural tension that is balanced by the history of and the expected future margin structure of a business.
Get Non-Operating Assets Off the Balance Sheet
Some business owners intentionally place non-operating assets on the balance sheets of their companies. We mentioned farmland, artwork, vacation homes and more earlier. Other business owners accumulate excess assets, like cash and marketable securities, on the balance sheets of their companies.
I am a believer that the balance sheet of a business should be maintained strictly for the benefit of the business. My rationale is simple. Non-operating assets do a number of bad things, including:
- Dampen returns for all shareholders.
- May cause management to become “comfortable” with lots of cash around.
- Distort the income statement with items of income or expense.
- May be difficult to address in the context of an unexpected transaction opportunity.
On the last point, non-operating assets can increase the difficulty of sale when that time eventually comes. I’ll provide a couple of examples:
- Lifestyle assets. Your company owns a condominium at the beach in Destin, Florida. No buyer of an operating business wants that kind of asset. You will either be faced with distributing it to owners (you can keep the living room!) or selling it, likely unfavorably, in favor of getting the larger transaction accomplished. If the buyer takes the condo, it will almost certainly be at a discounted value to compensate him for the inconvenience of having to deal with it.
- Excess cash. When most companies are sold (or their assets), the buyer expects to obtain an agreed upon amount of working capital. What I can say from experience is that if your company has a long history of maintaining excess cash, the buyer will argue that you must need all or a portion of it for normal operations. It is far better to distribute the excess cash/securities to the owners and operate with a normal balance sheet. You won’t have to argue over cash that is not on the balance sheet.
We have briefly discussed normalizing adjustments in this and the previous post. Let me leave you with a couple of concluding observations about them:
- Consideration of appropriate normalizing adjustments is part of any appraisal process and any due diligence process of potential buyers.
- The identification of normalizing adjustments requires investigation.
- Perhaps the best way to validate the reasonableness of a set of normalizing adjustments is to examine the implied margins (e.g., the EBITDA margin) relative to a company’s history or peer group(s).
- Not everything that seems unusual or non-recurring at first observation will qualify as a normalizing adjustment.
- For every balance sheet adjustment, look for a corresponding income statement adjustment.
I made the point strongly that it is best to get excess, redundant or non-operating assets off of a company’s balance sheet to help insure that questions surrounding their sale or transfer do not reduce the marketability of the business.
Next week, we will look at the EBITDA Depreciation Factor in some detail to wrap up the discussion of the single period income capitalization technique we introduced to capitalize EBITDA.
In the meantime, be well!
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