October 17th, 2024
Normalizing Earnings or Cash Flow
Posted on May 24th, 2024 in Business Valuations
Businesses with active operations are commonly valued based on their ability to generate earnings or cash flow. For mature businesses that demonstrate consistent earnings or cash flow, a Chartered Business Valuator (CBV) or other valuation practitioner may employ a capitalized earnings or cash flow methodology to assess the value of the business operations if future results are expected to be stable. Under this type of methodology, historical business results are analyzed to estimate a sustainable level of earnings or cash flow. A capitalization rate or multiple is then applied to determine the hypothetical amount an investor would pay for the business operations.
In order to determine the sustainable level of earnings or cash flow a business can generate, historical results are reviewed. Adjustments are made to the reported results to arrive at “normalized” earnings or cash flow, which are then considered when selecting the sustainable level or range. Below are some examples of common normalizing adjustments made to determine a business’s normalized earnings or cash flow:
Related Party Transactions
Businesses often have transactions with related individuals (such as shareholders or their family members) and companies controlled by these individuals. These transactions may involve discretionary payments or do not always reflect the economic value transferred. When normalizing earnings or cash flow, these transactions are typically adjusted to market rates that would be paid or received from an arm’s-length (unrelated) party. Examples include compensation paid to owners or their family members working in the business, rent for real estate or equipment owned by a related individual or corporation, sales or purchases with related entities, and consulting or management fees. These can be in the normal course of business, but they may sometimes be for other purposes such as tax planning.
Redundant Asset Adjustments
Businesses may own redundant assets — assets not used in active operations. Under an income approach, the value of redundant assets is considered separately from the value of business operations to avoid double counting. Income or expenses related to these redundant assets are removed from normalized earnings. Examples include dividend or interest income from marketable securities and loans, investment management fees, and life insurance premiums. If a business owns real estate not essential for operations, treating it as a redundant asset involves adjusting earnings by adding back ownership costs and deducting a “market” rental rate.
Non-Recurring and Non-Operating Adjustments
Non-recurring items are amounts that are not expected to occur in the future on a predictable basis. Examples of non-recurring items include lawsuit settlements, moving costs, discontinued operations, and revenue from one-time projects. These nonrecurring revenues and expenses are removed from normalized earnings/ cash flow. Non-operating expenses are also removed and include personal expenses paid by a business on behalf of a shareholder.
Selecting a Maintainable Level:
There is no precise method or formula to determine the maintainable earnings of a business. Normalized historical results are one factor among others considered when estimating the maintainable future earnings for valuing business operations. Other factors include short-term budgets/forecasts, industry and economic data, management input on the future business outlook, and the professional judgment of the valuation practitioner.
If you have any questions regarding your business’s earnings or cash flow, please contact a member of our Financial Services Advisory Team (FSAT) team.
Article originally published in: FSAT News: Spring/Summer 2024
Article written by: Jonathan Corobow, CBV
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