Financial statements adjustments for business valuation
The American Society of Appraisers, in their Business Valuation Standards II, (Income Statements Adjustments) defines “financial statement adjustments” as “modifications to reported financial information that are relevant and significant to the appraisal process.”
They then go on to show where these adjustments are appropriate:
Of these four directives, the third one is the most important to small, medium, and closely held businesses. And the phrase: “reasonably representative of continuing results”; what does that mean?
The premise is that a fair market business valuation is the theoretical result of a price arrived at by willing and able buyer and seller with all the facts, etc. It follows then in any valuation calculations involving the income statement, that the income statement is adjusted to that which the buyer will enjoy as the new owner.
What adjustments would that include?
Non recurring revenue and expense items
Most often these appear in the income statement as “other income”, and should be adjusted out. Things that may be in this lot would include non operational income
- Letting a portion of the warehouse
- Sale of old equipment
- Grant funding
- Interest earned on cash reserves
- Dividends received from a non-core asset
Amortisation expenses
The structure of the eventual deal may require that all assets on the balance sheet are unencumbered. In other words they belong to the business which will be sold. So you may as well get the benefit of a higher base profit figure in your formulas.
Piggy back contracts
Vehicle rental agreements, security companies, short term insurance, and similar contracts often have benefits to business owners who by virtue of including them on a business package or in a bulk purchase . These should all be adjusted in the operational costs before business valuation calculations commence.
Non core salaries
Small and closely held business owners will know exactly what this means. It usually manifests itself in a spouse or a child working for the company in a role which is perhaps paid much more than the value added to the company. Of course those non-core salary earners are paid through the normal salary channels. As such they pay their PAYE, UIF, and union subscriptions as any employee would.
Hell, I have even heard of business owners paying their spouses almost as much as themselves, for relatively little work at all.
Interest payments
A business valuation which is conducted for reason of a planned owner exit at some stage can and should adjust the finance costs to the business. The rationale is that a new owner will have a different set circumstances.
The new board may be very conservative and debt averse, in which case their interest bill be nil, after the acquisition.
Their credit profile of the directors may attach a higher interest rate. Or a lower interest rate!
The weighted average cost of capital (WACC) goals of the new board may be different.
The covenants set by the new board’s bankers will almost certainly be different.
Non-core maintenance expenses
Similar to piggy-back expenses, from time to time maintenance on personal property will be paid for by the the company. Those events should be adjusted out of the operating expenses before the valuation calculations start.
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ASA BVS-IV
“Anticipated benefits may be reasonably represented by such items as dividends or various forms of earnings or cash flow,”
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