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What are Normalization Adjustments in a Business Valuation?

November 12, 2015

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When we are valuing a company and are presented with financial statements, typically we ask the owner questions regarding their business operations. We try to obtain information beyond financial data so we can normalize certain financial statement items to use in the valuation.

Normalization Adjustments

For example, if we were to value a company using an income approach (assuming we have determined that an income approach would be the most appropriate in the valuation of the company), we start by taking the income before taxes figure from the financial statements. Next, we add back any interest expense and amortizations to arrive at earnings before interest, taxes, depreciation and amortization (“EBITDA”) for each year, or alternatively, add back interest expense to arrive at earnings before interest and tax (“EBIT”). After determining EBITDA (or EBIT), we factor in normalization items to determine a “normal” level of business operations. Some normalization items include:

  • Unusual or non-recurring items – include one-off transactions that do not reflect normal business operations. Examples include any gains from the sale of capital assets or legal fees incurred arising from a lawsuit.
  • Non-business expenses – include personal meals and entertainment, or personal travel expenses that may have been recorded in the books of the business. As these costs do not contribute to the company’s operations, they would normally be added back.
  • Discretionary expenses – include costs that were incurred by the business but are not essential for the company to operate. Examples include donations to charities and bonuses to shareholders.

The above list is not exhaustive but provides examples of some things that we consider in the valuation of a business. After normalizing certain items from EBITDA (or EBIT), we arrive at a normalized figure that will then be used in deriving a value of the company.

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