You will not hear the term ‘normalising’ the P&L very often. When you do, it is often an indication that the business is in a frame of mind open to change.
It is a common starting point of valuing a business, a process that has two basic buckets:
- Financial value. This is where any valuation process will start, with the numbers.
- Strategic value. Far more qualitative than the numbers, a potential buyer will set out to put a value on such things as market share, customer profiles, geographic location, cultural fit, and so on.
Valuing a business is a complex exercise, particularly valuing the contents of the ‘strategic bucket’.
Creating a financial value is much better understood, and almost always starts at the same place: EBITDA. Earnings Before Interest, Tax, Depreciation, and Amortisation.
EBITDA is a construction of the profit and Loss account, which reflects the trading results. Usually the P&L is completed on a monthly basis, and so long as the classifications of the expenses remains consistent, can be used for comparisons over time to give a good picture of trends.
However, the P&L can also be the repository of all sorts of costs and activities that bear little relationship to the competitive trading health that determines the value of a business. Therefore, an exercise to arrive at a value will seek to remove from, or add back, items that reflect more accurately the trading health. The usual term is to ‘normalise’ the P&L.
This is particularly relevant in the sale process of a private company, less subject to the rigors of governance that apply to listed companies with professional rather than family management.
The common items to be ‘normalised’ I have seen are:
Related party revenue or expenses. Purchases from, or sales to another business related in some way to the one being investigated, that are above or below market value. A common practise is for the owner of a private business to have their superannuation fund own the premises from which the business operates. The premises are then leased back to the operating business at a rate not reflective of competitive market value.
Owner bonuses and benefits. Often the owner of a private business will pay themselves and family members more than the market value of their contribution to the business. It also works in reverse, owners are sometimes the worst paid staff members, working longer hours than anyone else, just to keep the wheels turning over. These anomalies need to be ‘normalised’
Support of redundant assets. Every business has redundant assets that would be jettisoned by a new owner. This stretches from old inventory still carried on the books, to premises not utilised, to the country retreat used occasionally for a sales conference, but usually for the summer holidays of the owner. These do not realistically impact the performance of the business, and a new owner, unencumbered by the past, and by costs not associated with the trading position of the business, will remove them from the P&L.
Asset and expense recognition. Treating an expense as an asset, ‘capitalising’ an expense is a common practise that will boost short term profitability by moving items from the P&L to the balance sheet. While this practise is subject to the scrutiny of tax and accounting rules and independent audit, it is pretty common. It is particularly common in the treatment of repairs and maintenance. As with many items, the accounting treatment can be used both ways to ‘manage’ short term profitability.
One time costs. Items such as litigation, insurance claim recoveries, one-off professional fees, even charitable donations, that are not a normal part of trading operations need to be identified and ‘normalised’ to build the picture of repeatable trading outcomes.
Inventories. Every business has inventories, for many it is a significant item. Manufacturing businesses have physical inventories in raw material, Work in Progress, and finished goods, while service providers have projects in various stages of completion. The method of valuation of inventories is subject to all sorts of shenanigans, and the amount of inventory, subject to mismanagement, sloppy processes, and a host of other curses. Aggressive and consistent inventory valuation is a vital part of understanding the working capital needs of a business, and it often the most contested piece in the valuation puzzle.
When you have all that out of the way, you should be able to calculate a reliable figure for the free cash flow generated, or consumed by the business. A further vital number, and the one upon which many acquisition/divestment decisions have been taken.
As a consultant, looking to help businesses improve their financial and strategic performance, I often quietly do a ‘normalisation’ exercise on a clients P&L. This process almost always offers up those difficult questions that need to be asked and answered before an improvement process can be truly effective.
Header cartoon credit: Dilbert and Scott Adams again capture the idea.
