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Unlocking True Value: The Critical Role of Normalization Adjustments in Business Valuations

20 May 2024 12:51 PM | Kelsey Peake (Administrator)

By Syndey Weber, Marcum LLP | AAML Pennsylvania Platinum Partner

Normalization adjustments are an essential component of any business valuation. They are necessary to ensure that the operational results and financial position as reflected on the subject company’s financial statements or tax returns accurately indicate the anticipated profit or loss on a going-forward basis. Valuation experts make normalization adjustments to the income statement to eliminate expenses that are non-recurring or unrelated to the business, as well as to properly account for expenses such as rent or officer compensation that may not be accurately reflected. Adjustments may also be made to the balance sheet in order to remove non-operating assets or adjust assets to fair market value. This article focuses on adjustments commonly made to the income statement. 

The first step in normalizing the income statement is to determine the unadjusted Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA, a key indicator of the profitability of a business. To do so, all interest, tax, depreciation, and amortization expenses are added back to the business’s reported net income. Once these preliminary adjustments are complete, the normalization adjustments are made to reach normalized EBITDA. 

Following are some of the more common income statement normalization adjustments:

  1. Reasonable Compensation: In closely-held businesses, the owner typically draws a salary that may be considered “discretionary”. If the business is a sole proprietorship, the owner does not receive a salary at all. To ensure the business’s normalized EBITDA is accurately represented, it is necessary to make an adjustment reflecting the market rate that would be paid to a non-owner providing the same services. In this adjustment, the officer’s compensation reported on the income statement is added back to net income, and the reasonable compensation determined by the valuation expert through industry research is deducted. This adjustment removes the impact caused by a business owner receiving profits as a salary. It ensures EBITDA is not overstated by reflecting the appropriate market rate of compensation for the owner’s services.

  2. Discretionary Expenses: Adjustments need to be made for expenses paid through the business that are not essential to its operations. Generally, any expense that would not be necessary for a potential buyer to incur to maintain the business’s operations should be added back to the reported net income. The types of discretionary disbursements that are adjusted can vary depending on the nature of the business. They may include all or a portion of travel and auto, meals, entertainment, club dues, and credit card charges. Following discussions with the business owner, expenses may be deemed partially discretionary in certain circumstances. In this case, a percentage is often applied. Additionally, discretionary expenses that may not be immediately apparent to the valuation expert can usually be identified through discussions with the business owner. It is important to note that an expense that may be deductible for tax purposes could still be classified as discretionary for valuation purposes.

  3. Rent Expense: When the real estate from which the business operates is owned by the business owner personally or through a related entity, the rent charged to the business may not be representative of the fair market, meaning the business is paying either more or less than would be paid to an independent third party. A real estate appraiser generally determines fair market rent. If the business pays an amount over fair market rent, the excess would be added back to net income. Conversely, the differential would reduce net income if the amount paid is below fair market rent.

  4. Non-Recurring Income and Expenses: Any reported income or expenses that are not expected to recur in the future can skew EBITDA and should be adjusted. The adjustment for a non-recurring income or expense item would decrease or increase net income, respectively. Examples of non-recurring income and expenses include settlement fees for legal actions, one-time expenses for repairs or maintenance, income or loss from discontinued operations, and gains or losses on sales of assets or other investments.

Income statement normalization adjustments play a vital role in determining a business’s expected ongoing operational performance. These adjustments help ensure the conclusion of value is both reasonable and adequately supported.

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