How Normalizing Adjustments Impact Your Business Valuation

You may have heard the phrase, “Business valuation is a mix of art and science.” While there are mechanical aspects of the various valuation approaches and methodologies that must be considered, there is also a level of professional judgment present in every valuation. Normalizing adjustments are a key component of this “art” side of valuation. Valuation experts typically use a company’s financial statements and tax returns to begin their analysis. These statements (whether audited, reviewed, compiled, or internally prepared) include a company’s reported earnings, which may contain personal, unusual, non-recurring, or non-operating expenses (or income).

When performing a business valuation, it is important to analyze the company’s historical financial statements and make adjustments to, or normalize for, any discretionary, non-recurring, or non-operating items that a hypothetical new owner would not expect to incur in the future. The purpose of normalizing adjustments is to determine the income and cash flow a company can expect to generate going forward based on its historical results. Valuation experts work with management to review and question expense trends and fluctuations and determine what adjustments, if any, are necessary to accurately present the company’s economic income and balance sheet. Common examples of normalizing adjustments include:

Income Statement

Discretionary expenses

Does the company incur expenses that are personal in nature or paid at the discretion of the owners? In other words, would a hypothetical buyer need to incur the same expenses to operate the business? Discretionary (or personal) expenses typically include personal travel, meals and entertainment, charitable contributions or donations, and auto expenses.

Officer compensation

If the owners of the company work in the business, what would be the market rate to replace them? If members of management are currently overpaid or underpaid for their services, then a normalizing adjustment would be necessary to adjust their compensation to fair market value. For example, if owner compensation is $350,000, but fair market compensation is $200,000, a normalizing adjustment would be made to reduce the officer compensation expense by $150,000 (along with the related payroll taxes), which would increase the company’s normalized benefit stream.

Unusual gains/losses

Does the company have any one-time or non-recurring income or expense items that are not expected going forward? A simple example of this is PPP loan forgiveness income, since a new owner would likely not see similar income in the future. This necessitates a normalizing adjustment.

Balance Sheet

Fixed assets

Is the net book value of fixed assets indicative of fair market value or is PP&E more/less valuable than the reported net book value? For example, an adjustment is necessary if management believes the net book value of the fixed assets is different than the fair market value of the underlying assets (such as when a company holds an appreciated piece of real estate).

Accounts receivable

Are there any receivables on the company’s balance sheet that may not be collectible? If so, it would be appropriate to write down the receivable balance to the amount that is expected to be collectible.

PPP loans payable

Does the company have a PPP loan liability on the books? If so, and if the balance is expected to be forgiven, it would be appropriate to write off this liability for purposes of valuing the company.

Normalizing adjustments play a crucial part in the valuation process as they enable a valuation expert to determine a business’s sustainable income and adjusted balance sheet. Company management can also assist valuation experts with this process by identifying potential adjustments. Only when these adjustments are properly considered can an accurate determination of value be reached.