Definition - 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.
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.