What Does Normalize Mean?
Normalization is a financial process where any nonrecurring expense or income is removed from financial calculations, such as EBITDA. The idea behind normalization is to give the management and its stakeholders an idea about the future earning capacity of the organization. This is why it is a common practice to use normalized earnings as a denominator to assess profitability.
Divestopedia Explains Normalize
Normalization is often performed with EBITDA. One of the best measures of a company's operating cash flow is EBITDA as it takes into account cash inflows and outflows before adjustments. Besides these expenses, there are other cash outflows that are nonrecurring and do not come as a part of the company's operating expenses. These expenses have to be deducted as well, hence normalization must be performed.
Some expenses that fall under normalization include:
- Management salaries — This is one of the trickiest parts of normalization because there are some salaries that recur every month while others, like severance pay, are paid only once to outgoing executives. Hence, each expense should be analyzed individually to determine whether they should be deducted under the process of normalization.
- Salary paid to family members — Sometimes, family members are on a company's payroll and receive a certain amount of money each month; however, when they don't do any work for the company this causes a mismatch. Hence, the salaries paid to these family members should also be deducted.
- Benefits accrued to the owner — Owners may sometimes get life insurance, loans, key man insurance or a pension which are contributed to from the company's funds. Since they are not recurring and do not contribute in any way to the everyday operations of the company, these expenses should be normalized.
- Nonrecurring expenses — Besides the above expenses, there may be other one-time and nonrecurring expenses including costs paid towards non-operating assets. Since such expenses are not part of the company's operating expenses, they have to be normalized as well.
The above expenses paid to owners and family members are called Type 2 Normalizing Adjustments. Other types are called Type 1 Normalizing Adjustments.