What Are Normalizations To Cash Flow And How Do They Affect Value

WHAT ARE NORMALIZATIONS TO CASH FLOW (OR EBITDA)?

Business owners generally know their financial statements are prepared according to accounting rules and do not always provide the most useful information, particularly when it comes to providing insight into the value of their business. Furthermore, many business owners think that because their financial statements are audited or reviewed by a chartered accountant that they are clean. While they may be clean for financial reporting purposes to the bank, for valuation and M&A purposes, a different definition of clean is used. When calculating the cash flows of a business there are many aspects that must be taken into consideration to determine what the cash flow is. Expenses are added to and subtracted from the cash flow to arrive at the adjusted operational cash flows. Items that have been expensed and are not part of true operational expenses of the business should be added back to determine the adjusted cash flow. Conversely, expenses that have not been accounted for which are true operational expenses should be subtracted from the cash flow.

EXAMPLES OF NORMALIZATIONS THAT WOULD INCREASE CASH FLOW:

n If the shareholders of the company paid out management fees to themselves each year, which are in excess of what the fair market salary should be, the excess amount of a managers salary should be normalized, adding to the cash flow. The test for determining the amount of the adjustment is to determine what it would cost to hire a manager to replace the owner. If the fair market compensation is $200,000, anything paid to the owner in excess of this amount would represent the adjustment to cash flow. n If the company was involved in a lawsuit and paid legal costs for the litigation, 100% of these costs would be considered non-operational and should be normalized, adding to the cash flow.

EXAMPLES OF NORMALIZATIONS THAT WOULD DECREASE CASH FLOW:

n If a company rented their premises from a related company and the rent was below market, the cash flows of the business should be normalized downwards in an amount that would make the rental payments of the company reflective of what market rates were at the time of the lease was entered into. n No salary for management management compensation below market n R&D expenses n Under provision for warranty expense n Under provision for bad debt expense

HOW DO NORMALIZATIONS IMPACT THE VALUE OF MY BUSINESS?

Normalizations are very important in every valuation as the impact on cash flow is ultimately impacted by a multiple. For instance, in the example below, normalizations of $445,000 could result in $1.78 million of incremental value using a 4x multiple based on trailing years EBITDA.

What Are Normalizations To Cash Flow And How Do They Affect Value

EBITDA EBITDA Multiple Enterprise Value Normalizations: Excess Management Fees One Time Legal Costs Below Market Rent Total Normalizations Normalized EBITDA EBITDA Multiple Enterprise Value INCREMENTAL VALUE

a b axb=c e f g e+f+g = h a+h = i b ixb=j j-c

Zenith Manufacturing $1,500,000 4.0 x $6,000,000 $500,000 $125,000 ($180,000) $445,000 $1,945,000 4.0 x $7,780,000 $1,780,000

While the normalization adjustments do generally increase cash flow, some also reduce cash flow. Normalization adjustments should be considered carefully, because if too many normalization adjustments are included in arriving at adjusted cash flow, questions may arise as to the extent that the reported financial statements can be trusted. An abundance of adjustments resulting in significantly adjusted income statement is that the company was run as the owners personal piggy bank and not as a professionally managed business. As a general rule, the less adjustments to reported financial statements, the better.

What Are Normalizations To Cash Flow And How Do They Affect Value

ABOUT EQUICAPITA
Equicapita is a private equity fund that acquires established, private, small and medium sized enterprises (SMEs) located primarily in Western Canada. Equicapitas investment drivers are to acquire operating companies at attractive valuations, with a history of generating sustainable cash flow and proven management teams. Equicapita believes that there is: - a generational opportunity to acquire baby boomer SMEs; and - a funding gap in the $2 to $20 million enterprise value range. The retirement of baby boomer business owners has been described as triggering one of the biggest transfers of corporate assets on record in Canada. This creates an environment with an abundance of opportunities to acquire SMEs with long-term operating histories, at attractive cash flow multiples. Equicapita provides investors with access to this alternative asset class via an efficient RRSP eligible structure.

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What Are Normalizations To Cash Flow And How Do They Affect Value