13 Oct Financial Statement Adjustments
Financial statements are helpful for showing the financial activities of a business. They are based on accounting principles or income tax regulations and serve as formal financial records of the business’s activities. However, they do little for portraying the economic reality needed to find the true market value of a small to mid-sized business. Financial statements may include some transactions that are discretionary, non-recurring, or market driven in nature. Let’s look at some of the most frequent financial statement adjustments that should be considered during a business valuation.
- Rent Adjustment
If the rental agreement falls into the category of a non-arm’s length transaction (either the company itself owns the real estate, the owner of the business personally owns the real estate, or a separate but related holding entity owns the real estate), then a rent adjustment will have to be made to find the fair market value of a business. Because this pre-existing relationship exists between the tenant and landlord, the owner of the company may be leveraging that relationship to better negotiate the amount of rent the company pays or reports on its income statement as opposed to a fair market value. A valuation analyst must assume that a hypothetical buyer of the business would not benefit from the existing relationship between the business and real estate.
To find the fair market value of a business in an arm’s length rental agreement, the actual rent paid by the company (if any) is added back to its net income and then the fair market rent value is subtracted. The best way to determine the fair market rent is to review a real estate appraisal prepared for the owner-occupied real estate. If this is not available, online commercial rental sites, such as loopnet.com, can provide a wealth of comparable facilities for rent in the same city and state (or surrounding areas) of the subject company. To follow best practices, at least three comparable properties should be found. Take the average rental price per square foot of the comparable facilities and multiply this amount by the total square footage of the subject company’s operating facility. This is the amount that should be removed from the company’s cash flow in the most recent year.
- Owner’s Compensation
When it comes to compensating themselves, business owners can generally pay themselves as they please. After all, they own the business. Because of this, all officer compensation expenses must be added back to a company’s net income. If the owner had minimal involvement in running the business, the general manager’s salary can be added back to the company’s net income. In the case that there is more than one working owner, then a fair market replacement salary that a hypothetical buyer would be required to pay for an outside hire to perform the same duties as the additional owner(s) will have to be found and removed from the net income.
- Owner Benefits and Personal Expenses
Owner’s benefits such as health insurance, life insurance, pension, and other ownership perks directly benefit the owner. For a business valuation analyst, identifying these benefits on financial statements is critical when doing a business valuation as a hypothetical buyer may not benefit from these same perks. As such, each of these owner benefit expenses must be added back to the company’s cash flows in the year they were incurred.
In addition to their compensation and benefits, many business owners will often expense personal items to the company. Typical examples might include personal car expenses, travel and meal expenses, certain professional fees, and other expenses that benefit the owners/officers that deviate from the normal costs of operating the business. These are not operational expenses and are targets for adjustment when determining a business’s value.
- Normalizing Adjustments
Normalizing adjustments can occur in a multitude of different ways. The theory of normalizing adjustments is to show a hypothetical buyer the true earnings from a business’s normal operations. For example, a company may report fluctuating insurance expenses due to timing of payments. To arrive at the normalized amount, the analyst may take a historical average of the expenses amount and remove it from the net income during the period the expenses occurred.
- Non-Recurring Income
Companies may report secondary sources of income, that are not derived from its main business, in the form of “other income” on their income statements. To determine whether this other income should be included in the value of a business, you must first know what the income is related to. Often, this income is reported as interest, rent, net gains from the sale of an asset, or miscellaneous income. If the other income being reported is deemed non-operating or non-recurring, then it will have to be removed from the company’s cash flow accordingly.
In general, financial statement adjustments are made for expenses or other income that a hypothetical buyer would not incur or benefit from. Making these adjustments help ensure that the value of the business is considered fair market. It is important to note that for these expenses or other forms of income to be adjusted, they must be reported on the financial statements being used to appraise the business. If the expenses are not clearly defined, then adequate proof (such as a general ledger, invoices, CPA letter, etc.) must be provided for the adjustments to be justified. If an expense is not included on the financial statements (i.e., if owner’s health insurance was not deducted as an expense on these statements, even though paid by the company), you cannot adjust for it.