In a standard business valuation, an analyst makes adjustments to the company’s financial statements to better reflect economic reality. This process is known as normalization. Items that are unique to the current business or non-recurring are adjusted. Normalized financial statements allow better comparisons to industry averages and other similar companies. These normalized adjustments provide a more accurate picture of the company’s true earning capacity. Here are some of the most common types of valuation adjustments an analyst makes to the financial statements.
Assets which are not part of operations are removed from the balance sheet. Common non-operating assets include unallocated cash and marketable securities, loans receivable, idle equipment and vacant land.
Non-recurring or discretionary items and expenses
Items or expenses that are non-recurring are removed from the income statement. Additionally, expenses made at the discretion of management that are not normal to business operations are eliminated or reduced to common industry levels. This may also include expenses a business owner incurs for personal benefit. For example, travel and entertainment, charitable contributions, automobile expenses and legal fees are common adjustments.
Wages, salaries, benefits
Wages, salaries and benefits are adjusted to reflect current market rates. This compensation data can then be compared to industry statistics or job market data. Sometimes a company has employees on the payroll who are not actively participating in the operations of the business. This compensation is adjusted out.
The owner’s salary is discretionary and may not be continued by a new owner therefore it is excluded. In many cases, owners pay themselves simply what the business can afford rather than the market rate for the services they perform. An analyst determines a fair market value for the level of compensation for the services rendered and adjusts the excess.
Uncollectible accounts receivable
If some accounts receivable has been noncollectable for over a certain time period, it may be deemed irrelevant. With the change of ownership, the chance of it being collected declines significantly. A buyer can ask for the noncollectable accounts receivable to not be considered as part of the contract.
Like accounts receivable, unpaid liabilities can also be removed from the contract. Liabilities that are unpaid and have accrued interest may already be accounted for in financial statements.
Income tax regulations
Many small businesses use income tax returns as the best source of financial data. However, tax returns are often prepared with the intent to minimize taxable income, not to reflect economic reality. For instance, a company may elect to expense the purchase of capital assets that are normally depreciated over time. Keep in mind depreciation methods and periods are set by regulation, not by actual experience. And lastly, various components of goodwill are amortized over 15 years regardless of their expected economic life and value. Tax regulations impact the value of the business in a variety of ways. As such the data is adjusted to reflect economic value.
By removing discretionary, non-recurring and non-operating items from the company’s financial statements it gives a more realistic picture to the potential owner. A business appraisal will help you make these adjustments to provide a more accurate business value. The adjustments are then used in the business valuation to compare to similar companies and industry averages. Normalized financial statements can also be analyzed and used to make meaningful projections and forecasts.
Peak Business Valuation enjoys working with small business owners to help maximize their company value. Whether you are buying or selling a business, we can help normalize/adjust financial statements to give you a better picture of the company’s earning capacity. We welcome any questions you have. Please reach out via email or phone call.