What Does Normalization Mean?
Normalization is the process of removing non-recurring expenses or revenue from a financial metric like EBITDA, EBIT or earnings. Once earnings have been normalized, the resulting number represents the future earnings capacity that a buyer would expect from the business. One of the most common valuation methods is based on a multiple of normalized EBITDA, so "normalizing up" a company's EBITDA is a common motivation of sellers and investment bankers when marketing a business.
Smart buyers are watchful of these normalization adjustments to ensure they are legitimate so that they don't end up paying a multiple on earnings that will not be realized in the future. A significant portion of buyer due diligence is dedicated to reviewing normalization adjustments made by the seller, as well as looking for non-recurring income that may reduce EBITDA and the purchase price.
Divestopedia Explains Normalization
Normalizations are usually made under one of the following scenarios:
- One-time expenses or revenues not expected to occur each year;
- Amounts that have not been recorded in the financial statements at fair market value; and
- Overly aggressive or conservative application of an accounting policy.
Sellers sometimes try to normalize for expenses that they believe a buyer will not incur after the acquisition.
These adjustments are considered to be a cost savings occuring from post-transaction synergies, and most buyers will not accept them as a normalizing adjustment. Similarly, sellers sometimes try to adjust for expenses that should have never occurred in hindsight. These are true operating costs that have resulted from poor cost management. Buyers will never accept poor cost management expenses as normalizing adjustments, because they may recur in the future, particularly if the same management team remains post-transaction.
The 10 most commonly encountered normalizations include:
- Non-arms-length revenue or expenses;
- Revenue or expenses generated by redundant assets;
- Owner salaries and bonuses that are not at fair market value;
- Rent of facilities at prices above or below fair market value;
- Start-up costs;
- Lawsuits, arbitrations, insurance claim recoveries and one-time disputes;
- One-time professional fees;
- Capital expenses recorded as repairs and maintenance;
- Inventories previously expensed that still remain in the business; and
- Other income and expenses that remain uncategorized and are non-recurring.