Financial statements are an important source of data for valuing a business. But they tell only part of the story. An accurate business valuation hinges on a comprehensive understanding of the subject company’s relative performance and its future earnings power. To help clarify matters, experts often make various adjustments to the financials. Here are some examples.

Non-recurring adjustments

From a valuator’s perspective, an obvious shortcoming of financial statements is that they demonstrate historic results, not expected performance. Historical data is less relevant if operations are expected to change in the future.

For example, a valuator might remove extraordinary or unusual items — such as proceeds from a legal settlement or short-term effects of hurricane damage — from a company’s income statement. Similarly, to better reflect future earnings potential, financial statements may require adjustment for, say, profits related to discontinued product lines or expired customer contracts.

Normalizing adjustments

Valuators also use financial statements to compare a company to its peers. Specifically, assessments of the subject company’s performance affect the market approach (when selecting comparables and calculating pricing multiples) and the income approach (when estimating future earnings and quantifying the cost of equity).

If a company deviates from Generally Accepted Accounting Principles (GAAP) or industry accounting norms, benchmarking may result in apples-to-oranges comparisons — unless valuators make the requisite adjustments.

Examples of normalizing adjustments include depreciation expense, cash-to-accrual reporting, lease accounting and bad-debt adjustments. Normalizing adjustments are especially common if the subject company’s financial statements are unaudited or based on tax regulations, rather than GAAP.

Control adjustments

Public companies are subject to SEC regulation and analyst scrutiny, so they usually operate to maximize and stabilize earnings per share. But private companies are different.

For example, many private business owners intentionally minimize income to lower taxes. Some may give preferential treatment to related parties or put relatives on the payroll who aren’t essential employees. Or they may commingle personal assets and expenses with those of the business. In cases such as these, a control adjustment may be appropriate.

On the other hand, control adjustments may not always apply. For instance, a valuator might not adjust for owner’s compensation when valuing a minority interest that lacks the requisite control to change compensation policy.

Balance sheet adjustments

Because financial statement adjustments require double entries (a debit and a credit), many income statement adjustments also affect the balance sheet. But balance sheets themselves may be incomplete.

Consider internally generated intangibles (such as patents and copyrights), contingent liabilities (such as unreported warranties, unfunded pension obligations and pending lawsuits), and useful (but fully depreciated) assets. These unreported items would interest a potential investor and, therefore, affect value.

Another noteworthy balance sheet item is non-operating assets, such as marketable securities, unused equipment or excess working capital. They may require adjustments to the company’s income statement (for any related income or expense) and a separate addback to the valuator’s preliminary value estimate.

To adjust or not to adjust?

Experts understand when it’s appropriate to take a red pen to the financials. Determining which adjustments are appropriate — and when — is a complex undertaking that requires mastery of accounting, taxation and business valuation.

(This is Blog Post #1204)