Historic performance does not directly determine the value of a business. Instead, investors are more interested in the future economic benefits the business will generate. Past performance is only relevant to the extent that it demonstrates trends and is expected to continue going forward. This forward-looking approach applies whether an appraiser uses the cost, market or income approaches.
Why We Adjust the Financials
Financial statement adjustments are an important part of the valuation process. Some reasons valuators make these adjustments include: presenting historic financial information under normal operating conditions, to predict future cash flows, to adjust for accounting practices that differ from industry standards, to make comparisons with other companies easier, and to compare the small business owner’s compensation with industry norms.
Financial statements may need to be adjusted when using past results to predict future performance. There may be nonrecurring, noneconomic or other unusual items that would have an effect on cash flows. These normalizing adjustments eliminate anomalies and make comparisons with benchmarks and guideline companies easier.
In addition, some financial statement adjustments are made to estimate future economic benefits on a control basis.
All of these adjustments are hypothetical in nature. They aren’t intended to restate results or forecast future performance. Valuators base these adjustments on their professional judgment to get a clearer picture of the company’s future anticipated economic benefits.
How Do Adjustments Affect Value?
If the appropriate normalizing adjustments are not made, there could be a significant overstatement or understatement of value.
For example, suppose an appraiser estimates a value of $1 million by capitalizing next year’s expected cash flows of $200,000 using a cap rate of 20 percent ($200,000 divided by 20 percent equals $1 million).
In this case, each dollar of normalizing adjustments equates to a $5 change in value. If an appraiser increases expected cash flows by $50,000 to account for a nonrecurring loss, the hypothetical company’s value would increase by 25 percent to $1.25 million. So, seemingly small normalizing adjustments can have a big impact on value.
How Are Adjustments Supported?
A review of a business’ financial statement may not obviously show all adjustments. So, the process of developing adjustments requires extreme close attention from the appraiser. Some of these adjustments must be quantified by the following documents and procedures:
- Tax returns and other historic financial statements
- Audit records
- Asset appraisals
- Footnotes to financial statements
- Site visits and interviews of management
- Third party verification;
- Industry research and benchmarking
- Consultation with experts in other pertaining fields
How Adjustments Affect Other Valuation Elements
Normalized adjustments also provide valuable insight that appraisers use to see a more complete picture of the company and its potential risks.
This extra insight allows valuators to select discount, capitalization and growth rates, as well as identify non-operating assets (and liabilities) to add to (or subtract from) a preliminary value conclusion. This exercise is also helpful when deciding on the appropriate capital structure or valuation discounts that apply to the business interest.
Valuing a private business interest is a complex process that includes many interrelated steps. The process of determining normalizing adjustments creates a foundation that valuators draw on throughout the appraisal process. Schedule a meeting with Filler & Associates to discuss adjusted financial statements for your business.