What are Normalized Earnings?
Normalized earnings refer to adjustments made to financial statements to eliminate one-off effects that may impact the revenue. A fundamental premise of normalizing earnings is to help financial analysts, investors, and other stakeholders gain insights into a company’s actual financial performance from its core business operations.
Normalizing a company’s earnings also serves as the first step for corporate activities, such as mergers and acquisitions, business evaluation, and benchmarking. A typical example of normalization would involve removing the sale of an immovable asset from a retail company’s financial statements in which a large part of capital gain was a result of selling food products, and not selling the asset.
Thus, normalized earnings flatten the earnings fluctuations to provide an estimated value of average earnings that omits nonrecurring charges or gains that a company would realize in a year.
- Normalized earnings are retrospective adjustments in the financial statements to eliminate the one-off effects of income and losses.
- Companies use normalized earnings as a tool for evaluating their financial health and overall performance over time.
- Normalization is used in various business activities such as mergers and acquisitions and business evaluation.
Understanding Normalized Earnings
Companies tend to eliminate the one-off effects of income and losses to represent their core businesses better. Companies use normalized earnings as a method for assessing their financial health and overall performance over time. More often, companies bear the brunt of one-off expenses, including the sale of old, non-operating assets or incurred litigation fees.
In such scenarios, although a company may realize costs and revenues that impact its cash flow, the costs do not reflect a company’s long-term term performance. In that case, the effects must be removed for proper analysis of a company, since they can portray an inaccurate position of a company. A higher amount of normalized earnings suggests that the company realizes high profits, regardless of a down year.
How to Estimate Normalized Earnings
Estimating normalized earnings requires information from income statements from previous years. The following are the steps followed when estimating normalized earnings:
1. Determine the number of years during which a company undergoes a typical business cycle. The period represents the time when the business fluctuates. Let’s assume that the average cycle of a business is four years.
2. Collect the most recent yearly income statements that correspond to the average business cycle. in our case, the income statements for the last four years are required.
3. Next, calculate the company’s net income or earnings for each annual income statement. Assume the company realized a net income of $90,000, $100,000, $50,000, and $110,000 in the last four years.
4. Find the sum of the company’s total net income in the last four years, using the income statements. In this case, $90,000 + $100,000 + $50,000 + $110,000 = $350,000 represents the total earnings for the last four years.
5. Next, divide the value of the total earnings obtained by the average cycle of business, which is four years, ($350,000 / 4 = $87,500), as the normalized earnings value.
The result implies that the company generates an average of $87,500 in a typical business year. It is worth noting that if a company uses earnings per share as its profitability metric, it can be substituted for net income in the calculation. If the normalized earnings are monitored over several business years, an increasing value suggests that the company’s financial health and value are also improving over time.
Examples of Normalized Earnings
The most common form of normalized earnings is when smoothening of the sales cycle is necessary or when revenues or expenses must be waded off, and it can be performed in two ways.
The first case is when a company in possession of a fleet of old vehicles replaces the depreciating assets with a new vehicle by selling the old fleet. The expenses or income realized are normalized to obtain its real average earnings. The company’s income statements are then assessed to eliminate the revenue earned through comprehensive income. In effect, it removes the operating expenses incurred during the purchase.
The second approach involves normalizing earnings for a company whose sales are seasonal. When sales occur in cycles, moving averages are used to adjust overtime earnings.
Investors use normalized earnings to compare the financial health of companies. In some cases, standard metrics, such as earnings per share, can be influenced by the time they were calculated. It is common when high profits are not related to the company’s core business activities realized during the period.
Therefore, earnings per share serve a better measure for investors to assess and compare a company’s core business operations, rather than basing the evaluation on a single and temporary revenue growth.
Special Case for Private Entities
Privately-traded companies may deviate from common industry standards of accounting. The reason behind the fact is that the normalization of earnings method is ideal within the course of business valuation for comparison purposes.
In such regard, a privately-held company may adopt the first-in, first-out method (FIFO). Although the technique may result in different values compared to the normalization of earnings, it can impact a company’s earnings value.
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