This article originally appeared in the March 2017 issue of Smart Business Philadelphia magazine.
Normalized earnings represent adjustments to a company’s earnings to remove the effects of nonrecurring items, such as one-time gains or losses, unusual items, and the impact of seasonal or cyclical sales. This calculation is often used to provide business owners, prospective buyers, and others with a company’s true earnings and its repeatable stream of economic benefits, says Richard Snyder, CPA, Director of Audit & Accounting at Kreischer Miller.
Smart Business spoke with Snyder about the benefits of determining your normalized earnings.
How are normalized earnings calculated?
There are generally different types of adjustments to normalized earnings: Non-recurring gains, losses, and discretionary expenses and adjustments for seasonality or cyclical sales cycles.
Non-recurring, one-time items may include expenses such as lawsuits, restructuring charges, discontinued business expenses, one-time repairs, natural disasters, the write-off of a note receivable, and other abnormal expenses.
Non-recurring gains may include the sale of real estate or investments, insurance payouts, or a settlement from a lawsuit.
Discretionary expense adjustments may include, but are not limited to, items such as salary or bonus adjustments, or adjustments for related party rents.
Often, owners of closely held businesses may pay themselves a salary which is not reflective of current market rates that would be paid if an outside person were hired to run the business. In situations where a company pays rent to a related party, the rents may not be reflective of the current market, which may require an adjustment to normalize. Cyclical sales or seasonality are typically adjusted using a moving average over the number of periods in order to present normalized earnings.
What are some important things to know about normalized earnings?
Normalized earnings provide the ability to develop reasonable projections of a company’s future income-generating ability and can play an important role for owners and other stakeholders for a number of reasons. These can include buying or selling a business, the valuation of the business, or evaluating a business against its industry peers.
Past performance is generally relied upon in order to develop an expectation for future earnings and cash flow. In the event of a sale or acquisition of a business, earnings from the past three to five years are analyzed.
As part of this review, a number of adjustments may be required in order to better estimate what is reasonably expected to occur in the future. The selling or acquisition of a business relies heavily on adjusted earnings and cash flow figures in the determination of the purchase price. Consistent, reliable earnings and cash flows are important as this lends credibility to the financial record-keeping and reporting process, which in turn provides a level comfort to all interested parties.
Valuation of a business takes a similar approach in which the valuator is looking for one-time, non-recurring items to ensure consistent financial reporting in the determination of a business’s value.
What does the process of normalizing earnings allow a company to do?
Normalizing earnings allows businesses the ability to compare themselves against their peers. Comparing operating results and other important metrics can assist a company in determining its strengths and weaknesses against its peers.
This in turn provides companies with an opportunity to improve their business by analyzing those strengths and weaknesses and developing an action plan to address them.
Normalizing earnings is a common practice used for multiple purposes. Reporting financial information adjusted for one-time items or discretionary expenses provides users of that information a more realistic picture of a company’s financial results and a more reliable tool with which to estimate future earnings.
This can lead to a better decision making process for owners and stakeholders, whether it is for a valuation of the business, a buy/sell situation regarding a business, or evaluating one’s business against its peers. ●
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