Net Income Normalization: A Guide for Fair Company Valuation

To normalize net income is to recalculate the figure in a way that removes discrepancies that may make it hard to fairly compare the figure with that of another company. Normalized figures are often used in trying to produce a fair value for buying out a company. Because of this, most of the changes are designed to take account of factors that would alter in the event of a takeover.

Step 1

Adjust the expenditure figures to take out any costs that are unusual. This can include payments made to family members or other employees who don't perform work that justifies those payments. It can also include excessive spending on staff perks such as entertainment, life insurance or expenses for traveling to work.

Step 2

Adjust the expenditure figures to add in any costs that are not currently paid but would normally be expected. This could include paying full market rent on office or factory space if the current owners get a special deal from friends or family.

Step 3

Adjust expenditure figures for major salaries if those currently paid are particularly out of kilter with industry averages.

Step 4

Adjust the figures as required if the company currently uses unusual accounting conventions such as the way future revenues are accounted for or the system used for depreciating capital assets.

Step 5

Check whether the company uses the modified cash system, which is a hybrid of the cash system, by which transactions are recorded when money changes hands, and the accrual system, by which transactions are recorded when the money becomes owed. Modified cash allows the accountants discretion over which figures to record when, so adjust this to your preferred recording system.

Tip

Normalization is a custom process. This means the precise changes you must make to the figures depend both on the circumstances and your own discretion.

Warning

Normalized figures may breach regulations when used in some types of financial statement, for example those prepared for Securities and Exchange Commission filings by a publicly traded company.