Estimating a company’s value requires more than just reading its income statement or balance sheet. Valuation professionals look beyond historical results to assess future potential. To do that, your expert may make targeted financial statement adjustments to more accurately reflect the economic reality of the business. Here are four types of adjustments valuators may consider:
1. Nonrecurring adjustments. Financial statements reflect past performance, but buyers care about future returns. Historical data is less relevant if operations are expected to change from the past.
For example, a valuator might remove extraordinary or unusual items — such as proceeds from a legal settlement or short-term effects of damages from a natural disaster — 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.
2. 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 U.S. Generally Accepted Accounting Principles (GAAP) or industry accounting norms, benchmarking may result in apples-to-oranges comparisons — unless valuators make the requisite adjustments.
Examples include:
- Adjusting depreciation schedules,
- Converting from cash to accrual accounting,
- Correcting lease treatment, and
- Writing off bad debts.
Normalizing adjustments are often necessary if the subject company’s financial statements are unaudited or based on tax regulations rather than GAAP.
3. Control adjustments. Public companies are subject to U.S. Securities and Exchange Commission regulations 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 might 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 such cases, control adjustments may be appropriate.
On the other hand, control adjustments may not always apply. For instance, a valuator might not adjust for owners’ compensation when valuing a minority interest that lacks the requisite control to change the company’s compensation policy.
4. 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 affect value.
Another noteworthy balance sheet item is nonoperating assets, such as marketable securities, unused equipment or excess working capital. These items 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 consider all four kinds of adjustments in every business valuation, but not all of them may be appropriate for a particular company. Knowing when and how to make financial statement adjustments is both an art and a science. It requires a deep understanding of accounting rules, valuation theory and the nuances of the subject company’s industry. Our business valuation professionals know how to read between the lines to uncover what truly drives value. Contact us to determine what’s appropriate for your situation.
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