Expert: Arthur Naman - 5/23/2009

Question
Hi, I am looking to buy a business, I was told the best way to look at how much the business makes is to "normalize" the income statement to adjust for any unusual or one time type of debts or revenues, any suggestion on how I can do this.  I have the balance sheet, expenses, and income statement for the business.  Thanks.

Answer
I found -- Normalize means:  Removing items from the income statement or balance sheet that do not normally occur during the course of business to better estimate the value of a company.

I also found this as a definition:   This term can be applied to many aspects of accounting. It means to average or smooth out a set of figures so they are more consistent with the general trend of the business. This is usually done using a Moving average.

So, here's what I think you should do. First, you should be looking at a year's worth of income statements, by month to see what the business cycle is -- how do the revenues and expenses vary throughout a typical business year.

Second, see if there are any income or expense items which do not normally occur. For example:  suppose the business purchases a truck. This is probably not a normal annual business expense for most businesses; a truck may be purchased every five to ten years, but not annually. The truck purchase will show on the income statement as depreciation typically. You will need to know something about the industry in which the business is operating to know what is "normal" or "typical". So back out the abnormal revenue and expenses to arrive at a "normalized" income statement.

The objective is to end up with an income statement which allows you the purchaser to consider whether or not a normal or average year provides the income and cash flow to support the price being paid for the business.