Normalized Earnings are adjustments made to the income statement in preparation to show potential buyers of the company. These adjustments eliminate expenses that are not usually incurred for the production of the business. To show a more realistic return on investment, the expenses that are normalized should not appear on the future buyer’s income statement.
Different Types of Normalized Earnings
There are multiple types of special expenses that are unusual on a typical income statement. For now, let’s categorize them into two types of normalized earnings – Type A and Type B.
Type A: Non-Recurring Gains and/or Losses
The goal of “normalizing earnings” is to provide prospective buyers a typical income statement so they know what to expect. Expenses such as a lawsuit, non-operating assets, and other abnormal items that occur once are considered expenses that can be eliminated when normalizing earnings.
Type B: Discretionary Expenses
Certain expenses may not be recorded at fair market value price. These expenses are adjusted so the buyer of a company will not assume these expenses are incurred regularly. If these expenses are included, the current company owners should specify that these expenses or earnings are not generating/generated by business. Examples include vacation homes, car rentals, start-up costs, and unreasonably high bonuses.
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Normalized Earnings Example
Laura Johnson is the CEO and founder of X company, and now wants to sell it. Her current business generated over $2 million last year, according to her income statement.
Type A: Laura experienced a lawsuit and lost $250,000. Because this was one-time event, the lawsuit expense can be removed for adjustment purposes.
Type B: Laura’s sales team had a sales contest to boost revenue for the year 15%, and two salespeople gained extremely high bonuses totaling to a $100,000 additional salary.
By normalizing these earnings, EBITDA increases by $350,000, earnings that the buyer can potentially make without those extra costs.