Business Valuation 101 – Normalizing Your Earnings
One of the key steps in preparing a business valuation involves “normalizing” the company’s financial statements to reflect the true economic performance of the business.
The goal is to eliminate anomalies, non-market transactions, non-recurring items, and discretionary expenses that do not reflect the business’s ongoing earning potential. Below is a list of common earnings normalization adjustments:
Owner’s Compensation Adjustments:
- Adjustments for owner’s salary and benefits if they are above or below a market rate. There are a variety of data base sources available to determine a market compensation rate.
- Removing personal expenses charged to the business by the owner such as non-business travel costs, personal gifts, or excessive meals and entertainment expenses.
Non-Recurring Items:
- Removing one-time expenses such as moving expenses, litigation costs, unusual bad debt losses, restructuring charges, start-up costs relating to new projects/products, or natural disaster-related costs.
- Excluding one-time income items such as gains from the sale of assets, insurance proceeds, legal awards for damages, government grants or subsidies (i.e. Covid wage subsidies).
- Adjusting for discontinued operations if a business segment or product line has been terminated.
Non-Operating Items:
- Removing non-operating income or expenses, such as investment income or expenses not related to core business operations (CRA penalties, foreign exchange losses, life insurance expenses).
Discretionary Expenses:
- Adjusting for discretionary expenses such as charitable donations or other expenses not necessary for business operations.
Accounting Method Changes:
- Adjustments for changes in accounting methods, such as changes in inventory valuation methods.
Related-Party Transactions:
- Adjusting for transactions with related parties that are not at arm’s length, such as above-market rent payments or below-market sales prices.
Extraordinary Gains and Losses:
- Removing extraordinary gains or losses that are not expected to recur in the future.
Interest Expenses:
- Normalizing interest expenses to reflect a typical capital structure for the industry, removing effects of non-standard financing arrangements.
Tax Adjustments:
- Adjusting tax expenses to reflect a normalized effective tax rate that is likely to be payable by a purchaser.
Owner Perquisites:
- Removing personal benefits provided to owners that are not necessary for business operations, such as personal vehicle expenses or family members on payroll.
Non-Cash Expenses:
- Adjusting for non-cash expenses such as stock-based compensation or impairment charges.
Unusual Revenue:
- Removing revenue from unusual or non-recurring sources.
Changes in Business Structure:
- Adjusting for any changes in business structure, such as mergers or acquisitions that impact earnings.
Economic Adjustments:
- Adjusting for macroeconomic conditions that might have temporarily affected earnings, such as temporary tariffs or short-term subsidies.
These adjustments ensure that the normalized earnings represent the company’s sustainable, ongoing earning power, providing a more accurate basis for valuation.
If you require assistance in determining a normalized earnings level for your business, contact one of our Chartered Business Valuators.
