31 May Normalization of Financial Statements
What is normalization?
The process is to remove non recurring expenses or revenue from a financial metric like the EBITDA (Earnings before interst, taxm depreciation and amortization). Once earnings have been normalized, the resulting number represents the future earnings capacity that a buyer would expect from the business. One of the most common methods of determining this number is based on a multiple of normalized EBITDA, so “normalizing up” a company’s EBITDA is a common motivation of sellers and investment bankers when marketing a business.
If you’re a buyer – and a smart one at that – you would be watchful of these normalization adjustments to ensure they are legit so you don’t end up paying multiple on earnings that will not be realized in the future. A significant portion of buyer due diligence is dedicated to reviewing normalization adjustments made by sellers as well as looking for non-recurring income that might reduce the EBITDA and the purchase price.
Normalizations are usually made under one of the following scenarios:
- One-time expenses or revenues not expected to occur each year;
- Amounts that have not been recorded in the financial statements at fair market value; and
- Overly aggressive or conservative application of an accounting policy.
Sellers will try to normalize the expenses that they believe a buyer will not incur after the acquisition. These adjustments are considered to be cost saving and occur from post-transaction synergies, and most buyers will not accept them as a normalizing adjustment. Sometimes, sellers will try to adjust for expenses that should never have occurred in hindsight. These are true operating costs that have resulted from poor management. Buyers will never accept poor cost management expenses as normalizing adjustments because it might recur in the future.
The 10 most commonly encountered normalizations include:
- Non-arms-length revenue or expenses;
- Revenue or expenses generated by redundant assets;
- Owner salaries and bonuses that are not at fair market value;
- Rent of facilities at prices above or below fair market value;
- Start-up costs;
- Lawsuits, arbitrations, insurance claim recoveries and one-time disputes;
- One time professional fees;
- Capital expenses recorded as repairs and maintenance;
- Inventories previously expensed that still remain in the business; and
- Other income and expenses that remain uncategorized and are non-recurring.