13 May Is it “normal” to adjust financial statements?
Normalizing adjustments change the income statement of a private company to show a prospective buyer or lender the return from normal operations of the business. One type of adjustment eliminates one-time gains or losses, non-recurring business expenses, and the like. Another type of adjustment is used for owner compensation that is above or below the market rate and other discretionary expenses that would not exist if the company was operated by another owner.
Privately held companies, when tax time comes around, want to show as little profit as possible. However, when it’s time to borrow money or planning to sell the business, they want to show just the opposite. Lenders and prospective acquirers want to see a strong bottom line. The best way to do this is to normalize, or recast, the income statement. The figures added back to the profit and loss statement are usually termed “add backs.” They are adjustments added back to the statement to increase the profit of the company.
For example, legal fees spent on litigation would be considered a one-time expense, as would be new equipment that is purchased to develop a new product. Adding back the money spent on one or more of these items to the profit of the company increases the profits, thus increasing the value.
If a company is valued at 5-times earnings (EBITDA), for example, an add back of $200,000 could increase the value of a company by one million dollars. Most buyers will take a hard look at the add backs. They realize that one-time expenses should be inspected closely as most businesses have “one-time” expenses almost every year. It’s also not recommended to add back the owner’s bonuses and perks unless they are really excessive. The new owners may hire a CEO who will require essentially the same compensation package.
The takeaway is that reconstructed earnings are a legitimate way of showing the real earnings of a privately held company unless they are puffed up to impress a lender or potential buyer. Excess or unreasonable add backs will not be acceptable to buyers, lenders or business appraisers. Nothing can ruin a potential financial deal faster than a break-even P&L statement padded with add backs.