What Does \u201cNormalizing Earnings\u201d Mean?<\/h2>\n
Earnings normalization involves reviewing reported earnings and making adjustments relevant to the valuation analysis. It does not change the original financial statements: adjustments are presented separately.<\/p>\n
The appraiser may examine non-recurring items, transactions between related companies or compensation that differs from the market-rate cost of the duties performed. This analysis may be necessary even when the financial statements have been audited. Source: MNP.<\/p>\n
The question to ask about each item is straightforward: what does it actually represent in the company\u2019s operations?<\/p>\n
1. Revenue: Distinguishing Ordinary Business Activities from One-Time Items<\/h2>\n
A strong year may include revenue that is not expected to recur.<\/p>\n
The appraiser seeks to understand where that revenue came from, the circumstances behind it and its connection to the company\u2019s ordinary activities. One-time revenue may need to be excluded from the earnings used in the analysis.<\/p>\n
Conversely, a major contract is not automatically non-recurring simply because its value exceeds that of previous contracts. It may reflect a genuine change in the business.<\/p>\n
What to prepare:<\/strong> An explanation of the revenue, the supporting records and the reasons you believe it may or may not recur.<\/p>\n An unusual expense may warrant an adjustment when it does not reflect the normal cost of doing business.<\/p>\n However, the appraiser must consider whether it could recur in another form. A company that records expenses described as exceptional every year must be able to explain why those costs should be excluded when assessing its earning capacity.<\/p>\n The analysis must also consider any costs that would replace an expense being removed. Removing a role or resource from the calculations does not eliminate the underlying operational need.<\/p>\n What to prepare:<\/strong> The invoice, the circumstances, how often the expense has occurred and any potential replacement costs.<\/p>\n An owner\u2019s departure does not mean that all of their compensation can be added back to earnings.<\/p>\n If you manage operations, develop sales or provide technical expertise, those duties will still need to be performed. The analysis therefore considers market-rate compensation for the responsibilities the business requires.<\/p>\n Compensation above the replacement cost may warrant an upward adjustment; compensation below that cost may require a downward adjustment. Source: MNP.<\/p>\n Prepare a description of your duties, the time you devote to them and any responsibilities that might need to be divided among several people.<\/p>\n Does your company lease its premises from another company you own? Does it receive services from a related business?<\/p>\n These relationships may involve prices or terms that differ from those independent parties would negotiate. The appraiser therefore considers whether an adjustment to market terms is appropriate. Source: MNP.<\/p>\n What to prepare:<\/strong> The agreements, the amounts recorded, the services actually provided and the evidence supporting the terms used.<\/p>\n Suppose a company reports EBITDA of $500,000. Following a review, three adjustments are accepted solely for this illustrative example.<\/p>\n In this case, normalized earnings are lower than the starting figure.<\/p>\n This example shows why earnings normalization must consider both favourable and unfavourable items. In an actual engagement, each adjustment would require justification and validation.<\/p>\n This hypothetical scenario is for educational purposes. The amounts and treatments are not benchmarks applicable to another business.<\/em><\/p>\n EBITDA stands for earnings before interest, taxes, depreciation and amortization. Normalizing EBITDA can help assess performance, but it is not sufficient to measure available cash.<\/p>\n Capital expenditures, changes in working capital, taxes and debt service must also be considered. A company can therefore have positive EBITDA while still requiring financing. Source: BDC.<\/p>\n Similarly, normalized EBITDA alone does not establish the value of a business.<\/p>\n Dependence on a customer or the owner requires specific analysis. It does not automatically translate into an expense to add or remove.<\/p>\n For example, allowing for replacement compensation does not necessarily resolve the difficulty of transferring the owner\u2019s business relationships.<\/p>\n The analysis must distinguish the cost of necessary duties from the risk that those duties or relationships may not be transferable. It must also avoid counting the same effect twice in earnings, forecasts or other valuation inputs.<\/p>\n For each proposed adjustment, prepare a brief summary that includes:<\/p>\n Maintain a clear reconciliation between reported earnings and adjusted earnings. The appraiser can then review the proposals, request clarification and determine the treatment appropriate to the engagement.<\/p>\n EBITDA<\/strong> Earnings normalization<\/strong> Non-recurring item<\/strong> Related-party transaction<\/strong> Replacement compensation<\/strong> Before your next meeting, review unusual items with your CPA or controller:<\/p>\n Preparing these answers helps you explain your earnings consistently and make the underlying assumptions clear. The conclusion remains the result of an analysis tailored to your business.<\/p>\n General information. Examples are hypothetical, and adjustments depend on the facts, the valuation date and the scope of the engagement.<\/em><\/p>\n <\/p>\n To document proposed adjustments, use our business valuation checklist of 12 documents to prepare<\/a>. To clarify the purpose of an engagement, read when to get a business valuation in Canada<\/a>.<\/p>\n2. Expenses: Determining What Would Actually Disappear<\/h2>\n
3. Owner Compensation: Accounting for the Work That Must Be Replaced<\/h2>\n
4. Related-Party Transactions: Examining Market Terms<\/h2>\n
A Hypothetical Example: Adjustments Work Both Ways<\/h2>\n
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\n Item<\/th>\n Effect on EBITDA<\/th>\n<\/tr>\n \n Starting EBITDA<\/td>\n $500,000<\/td>\n<\/tr>\n \n Removal of an expense considered non-recurring<\/td>\n +$30,000<\/td>\n<\/tr>\n \n Removal of revenue considered non-recurring<\/td>\n \u2212$20,000<\/td>\n<\/tr>\n \n Additional cost to replace the owner\u2019s duties<\/td>\n \u2212$40,000<\/td>\n<\/tr>\n \n Illustrative normalized EBITDA<\/strong><\/td>\n $470,000<\/strong><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n Normalized EBITDA Is Not Available Cash<\/h2>\n
Distinguishing Earnings Adjustments from Risk Analysis<\/h2>\n
How Can You Prepare with Your CPA?<\/h2>\n
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A Short Glossary<\/h2>\n
\nEarnings before interest, taxes, depreciation and amortization. This measure does not represent available cash.<\/p>\n
\nAn analysis of adjustments intended to make earnings more representative of the earning capacity relevant to the engagement.<\/p>\n
\nRevenue or an expense that is not expected to recur in the circumstances being analyzed. Its unusual nature must be explained.<\/p>\n
\nA transaction between related parties whose terms may differ from market terms.<\/p>\n
\nThe reasonable cost of the resources needed to perform the duties carried out by the owner or another person.<\/p>\nPreparing for the Appraiser\u2019s Questions<\/h2>\n
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<\/p>\nPrepare your valuation with your advisers<\/h2>\n