Normalizing Shines a Better Light on Company Financials

One of the many items on a prospective business seller’s “to do” list is to normalize — or adjust — their financial statements. This becomes necessary when various accounting methods have been used to reduce income and minimize taxes, and the business’s owner is paying expenses that a buyer might consider “extraordinary.” To help buyers understand your business, and ensure you get top price, engage a financial expert to perform this critical task before going on the market. 

Changing levels

Normalizing entails changing the level of expenses and revenues your business has been reporting to what a buyer might expect after acquiring your business. Many small businesses employ the cash method of accounting, which recognizes income when cash is received and expenses when bills are paid. But switching to the accrual method of accounting, and reporting income when a transaction occurs and expenses when goods and services are received, may present your company’s financials in a better light.

Your system of reporting depreciation may also harm the look of your business. If you currently use an accelerated schedule to depreciate assets, consider spreading your depreciation expense over a longer period, as a potential buyer would.

Owners and family members

Owner-operated businesses often compensate owners and other family members at higher levels than other companies pay their key executives. Buyers that may not wish to pay executives as generously would expect lower expenses allocated to salaries and bonuses. And because the company’s normalized payroll would be lower under different ownership, payroll tax would be adjusted as well.

Perks enjoyed by business owners — including company cars, club memberships and luxury hotels — may also need to be eliminated.  Financial experts adjust these expenses by removing anything a new owner might regard as excessive and placing them in line with industry norms.

Some business owners include their spouses and other family members under their company insurance policy coverage. Because a buyer presumably wouldn’t maintain this generous coverage, insurance costs would be normalized into a less comprehensive, standard coverage plan.

Inventory accounting

A financial expert is also likely to normalize inventory. Businesses often record inventory sales using the last in, first out (LIFO) accounting method. 

But given that the cost of inventory usually increases over time, the LIFO method more quickly reflects these recent increases as cost of goods sold, resulting in lower reported profits and lower taxes. Restating earnings with the first in, first out (FIFO) method makes for more robust profits.

Loans and leases

Depending on your business, there may be other items that require adjustment. For example, if you have bank loans or bonds outstanding with varying interest rates, a new buyer might be able to consolidate this debt with a lower overall rate. A normalized income statement would reflect potentially lower interest expenses.

Or, if your company leases real estate from another business you own, the lease may be set at an above-market rate to maximize your real estate earnings. Similarly, your business may be overpaying certain vendors or undercharging particular customers because of personal and family relationships that wouldn’t apply under different ownership. 

Realistic and useful

Don’t mistake the normalizing process as somehow fudging the numbers. When you adjust your company’s financials, you’re simply placing them in a more realistic and useful context for buyers. That normalizing also generally boosts a business’s value is a nice advantage for you. 

© 2014