Normalizing Income Statements for Business Sale Transactions

One of the fundamental roles of a business broker is to properly adjust, “normalize”, or “recast” the income statements and tax returns of a business to determine its true earnings power. Where the business has a track record of profitability and the promise of future earnings, market- and income-based methods of valuation are then applied to determine a reasonable price that a buyer should be willing to pay and the seller is likely to receive.

Normalizing involves a thorough examination of the income statement on a line by line basis to arrive at an economic EBT, EBIT, EBITDA, Discretionary Earnings (DE) or some other defined measure of adjusted earnings.  When determining net cash flows, historical balance sheets must be included in the analysis.

Normalizing income statements involves making three categories of adjustments:

1. Comparability adjustments to bring the financial statements more in line with accepted accounting practices, and to enable better comparison with similar businesses),

2. Control adjustments (e.g. owner compensation and fringe benefits, charitable contributions, and above or below market income/expense with related parties)

3. Non-recurring adjustments (e.g. sublease income that would not continue, and passive investment income that would not exist for the buyer)

After making the above adjustments, pretax net income (EBT) can be modified to arrive at Discretionary Earnings (DE) by adding back interest, taxes, depreciation, amortization and one working owner’s compensation. For small businesses (up to around $5 million revenue), DE is the most commonly used measure of earnings power.  Buyers can allocate DE to the following:

1. Compensating the new working owner, or compensating a general manager when a buyer intends to be absentee

2. Financing the purchase and working capital (interest and principal payments), usually through a bank and/or the seller

3. Making capital expenditures to replace fixed assets as they wear out or become obsolete, or invest in new assets to improve or expand the business

4. Paying income taxes (at the entity and individual levels)

The foregoing is an overview only. Determining cash flows and normalizing balance sheets is a discussion for another day. Doing this work correctly takes training and experience. Sellers must have their business broker or appraiser analyze three to five years’ financial statements for normalization purposes to understand how the business will be perceived by prospective buyers, investors and bankers.