Financial Statement Analysis and Normalization
Core concepts
Normalization converts reported earnings into economic earnings a hypothetical buyer would expect. Common adjustments: owner's excess or deficient compensation (replace with market compensation), discretionary personal expenses run through the business, nonrecurring items (one-time gains/losses, lawsuit settlements, casualty), related-party rent (adjust to market), nonoperating assets and income, and accounting method differences (LIFO vs. FIFO, cash vs. accrual, depreciation policy).
Analyze the statements with ratio and trend analysis: liquidity (current, quick), leverage (debt-to-equity, coverage), activity (receivables and inventory turnover), and profitability (gross, operating, net margins, return on equity). Compare to industry benchmarks and to the company's own history. Revenue quality-customer concentration, recurring vs. project revenue, backlog-matters as much as the margin.
Build a common-size analysis to spot structural shifts. Watch for balance sheet items that affect value but not income: excess cash, marketable securities, real estate, underused assets, and redundant liabilities.
Traps
- Normalizing owner's compensation in the wrong direction (adding back too much or too little).
- Failing to adjust related-party rent to market-this distorts both earnings and the real estate value.
- Double counting: adjusting earnings for a nonoperating asset and then adding the same asset to the balance sheet.
- Confusing a nonrecurring item with a recurring one; use multi-year history.
- Missing customer or supplier concentration risk embedded in otherwise healthy margins.
Worked rule of thumb
Owner takes $250,000; market compensation for the role is $120,000. Add back the $130,000 excess. If the owner instead takes $60,000, subtract the $60,000 deficiency. Always state the market-compensation source.
Exam strategy
List every adjustment with its dollar effect and rationale; a question may ask which adjustment is inappropriate, so know the boundaries.