Normalization Process Summary/Extended Analysis
This document is a summary of the complete Normalization Analysis file also placed onto the coursepage (not yet in finished form, however, as of October 31st, 2003). Although far from being complete, it captures many of the more important considerations and perspectives regarding the normalization of financial statements.
Earnings Versus Cash Flow
Prior to grappling with the many types of specific adjustments that are utilized to “normalize” the financial statements of the private firm, however, a quick perusal of the many different variations on the theme of “cash flows” will be helpful in understanding the inconsistent if not dynamic nature of the valuation realm. To begin with, there is an array of potential measures of earnings or cash flow. For example, the valuator of the smallest of private firms with an active owner-operator will often rely on some measure of “discretionary earnings” (this is the official term used by the International Business Brokers’ Association or IBBA) and the valuator of the larger, more substantial middle-market firms will often rely on some measure of “net cash flows” such as “net cash flow to equity”. The full spectrum of potential earnings or cash flow measures as used in the practice of business valuation for the private firm includes the following:
Common Measures of Earnings or Cash Flow
- After-Tax Income (Earnings)
- Pretax Income (Earnings)
- Earnings Before Interest and Taxes (Earnings)***
- Gross Cash Flow (Cash Flow)
- Earnings Before Interest, Taxes, Depreciation and Amortization (Cash Flow)*
- Excess Earnings (Cash Flow)
- SBA Adjusted Cash Flow (Cash Flow)
- Adjusted Cash Flow (Cash Flow, yet called “Discretionary Earnings”)
- Net Cash Flow to Equity (Cash Flow)**
- Net Cash Flow to Invested Capital (Cash Flow)**
*Referred to as "poor man’s cash flow" due to its oversimplifications as indicator of value; effective only when the firm has no plans to replace existing plant and equipment and has no debt service, i.e. rarely.
**Net cash flow to equity is referred to as "free cash flow" or "net cash flow from operations" and net cash flow to invested capital is referred to as "unlevered (debt free) net operating cash flow" by Kasper.
***Referred to as “operating income” because it represents income from operations prior to payments to “stakeholders” in the form of interest expense (creditors) and dividends (shareholders).
This list suggests that the many types of “cash flow” dwarf the possible measures of earnings, i.e. there are only a few measures of earnings and a multitude of potential cash flow measures. Amazingly, this seemingly exhaustive list does not include those unique “brands” of cash flow or earnings that have been creatively deduced by firms such as McKinsey and Company (Net Operating Profit Less Adjusted Taxes or NOPLAT) or by individuals such as Larry Kasper (Net Cash Flow from Operations), etc., etc. As one peruses the full assortment of books, articles and other publications dealing with private firm valuation, each and every one of the measures listed in table XX are found with varying degrees of frequency. As the heading above these measures suggests, certain items represent “earnings” and certain items represent “cash flow”.
The distinction is potentially as important as it is confusing, both theoretically and practically. For example, the measure referred to as “Discretionary Earnings” by the IBBA is actually a measure of adjusted “cash flow”. As Trugman indicates in his “Understanding Business Valuation” book,
"An appraiser will frequently find that using cash flow is a better measure of the company’s earnings capacity. This is particularly true when a more realistic picture is being sought of the amount of money that will be available to pay to the owners of the business as a return on investment. Many profitable companies go out of business, but it is rare that we see a business with solid cash flow go under."
Before proceeding further, let’s take a generic look at the difference between “earnings” and “cash flow”. To facilitate this discussion, we turn to Kasper’s “Business Valuations: Advanced Topics”. In general, earnings equal “Revenues – Costs”, where costs include taxes. In the so-called “discounted dividend models”, earnings are assumed to be:
"The cash available to shareholders except for replacement of assets"
- Operating Expenses
- Depreciation and Amortization
Cash flow, on the other hand, can be defined as:
- Operating Expenses (including interest/taxes)
- Depreciation and Amortization
+ Depreciation and Amortization
Based on these simple models, it is evident that earnings equal cash flow whenever investment equals current depreciation and amortization expense. The preference for “cash flow” described by Trugman is heightened when the amount of depreciation and amortization expense is relatively greater than net earnings and even moreso when the presence of above-market compensation for the ownership or other “normalization” adjustments apply to a given situation. For comparison purposes, consider Trugman’s basic net cash flow model:
Normalized net income
+ Normalized Noncash Charges
Gross Cash Flow
- Anticipated Capital Expenditures
+/-Working capital necessary to support growth
(or generated due to negative growth)
+/- Debt borrowings or repayments
- Preferred Stock dividends
Net Cash Flow
Unlike most “textbook” or other authoritative formulas for cash flow calculations, Trugman immediately highlights the importance of the “normalization” process in the presentation of net income and noncash charges.
Not all academicians, however, are convinced of the superiority of cash flow over earnings. Earnings have long played a major role in accounting and financial theory, including usage for valuing publicly-traded shares.
Overview and Examples of Normalization Adjustments
For the sake of expediency and clarity, the five general categories that were presented early in this segment shall be used for classification purposes. In other words, all of the potential adjustments faced by professional valuators when transforming the “accounting” financial statements into “economic” financial statements shall be grouped into one of the five general categories:
As noted throughout this segment, the actual normalization adjustments that are required in a given situation will depend on several factors, including:
- Interest being valued (minority or controlling; assets or stock)
- Source documents (financial statements or tax returns; cash basis or accrual basis or hybrid basis)
- Pertinent measure of earnings or cash flow (pretax or after-tax; ACF or net cash flow to equity)
- Valuation approach or method (asset or income; adjusted book value method or capitalization of earnings)
- Industry norms (FIFO or LIFO; accelerated or straight-line depreciation)
- Other situation-specific facts, considerations, issues (FASB 142 and goodwill impairment testing)
For the sake of expediency and clarity, the five general categories that were presented early in this segment shall be used for classification purposes. In other words, all of the potential adjustments faced by professional valuators when transforming the “accounting” financial statements into “economic” financial statements shall be grouped into one of the following five general categories:
- Officer/Owner, Shareholder or Family Member Compensation
- Unusual, Nonessential or Nonrecurring Events
- Non-Operating Asset-Related Expenses and Revenues
- Taxation Matters
- Accounting Policy/Procedure-Related Issues
The listed items may be either generic in nature (addition of part or all of owner compensation) or specific in nature (add travel and entertainment expense related to trade show event as a “perk” due to a lack of relevance or importance for this particular trade show, i.e. the expenses involved a vacation for the owners).
For maximum interpretation and understanding purposes, each adjustment should include the following components:
- Description and/or Goal of Adjustment
- Key Considerations
- Impact on Balance Sheet, Income Statement or Both
- Which earnings measure(s), valuation method(s) or specific situation(s) most applicable to this particular type of adjustment
Officer/Owner, Shareholder or Family Member Compensation*
- Addition of part or all of owner compensation (salary, payroll tax and perks)**
- Adjust the owner compensation upward due to current inability of company to pay normal level of owner salary
- Addition (subtraction) of family member compensation that exceeds (is less than) market value of contributed work
- Adjust balance sheet and income statement to reflect shareholder’s lack of intent to repay a company loan (note receivable), i.e. eliminate the asset and any accrued interest receivable on the note as well as the interest income recognized on the accounting income statement
- Adjust for below-market rent paid on real estate used by the company and owned separately by a major shareholder, i.e. reduce accounting profit by an amount which would bring the lease payment to market levels
- Add travel and entertainment expense related to trade show event as a “perk” due to a lack of relevance or importance for this particular trade show, i.e. the expenses involved a vacation for the owners
- Payments recorded as “office expense” were made to ABC Bicycle, Inc. and Merry Massage Maids (both deemed personal or discretionary) and are removed from operating expenses (to increase operating income, pretax income and after-tax income)
- Excessive meals and entertainment, e.g. addition of travel and entertainment expense related to trade show event as a “perk” due to a lack of relevance or importance for this particular trade show, i.e. the expenses involved a vacation for the owners
- Add unrecorded revenue in cash business to revenues, e.g. cash transactions that are not “recorded” in the books for either accounting or tax purposes
- Personal-related accounting/tax/legal advice paid for by the company, e.g. estate tax planning, should be subtracted from pretax income and operating income or added into ACF as a “perk”.
- Payment of management fees to companies affiliated through similar ownership at rates that are above market must be accounted for by elimination of the above-market portion of such expenses, i.e. either increase pretax or operating income or add as “perk” to ACF
- Attorney fees related to estate tax planning were removed from professional fees
- Payments to Neiman Marcus and the Body Shop found in the advertising expense category and personal magazine subscription payments found in dues and subscriptions were removed (added back into ACF)
- Office salaries paid to owner’s children have been removed after determining that such payments were not valid business expenses (personal or discretionary)
- Interest expense was added back into ACF due to its discretionary nature, i.e. a new owner may have no debt, the same debt or more debt***
*The adjustments in this category are typically associated with the valuation of “controlling interests” only (hence the earlier terminology of “control adjustments); the purpose and objective of the appraisal will determine to a large degree the exact amount of such adjustments, e.g. when using the cash flow measure ACF, it is proper and necessary to add ALL owner compensation irrespective of its relationship to “market levels” for such payments AND when using an Adjusted EBITDA measure, it may be proper and necessary to include ONLY the excessive compensation (above market levels) or possibly NO compensation whatsoever.
Examples in this category typically include: officer and owner compensation (salary, payroll tax and benefits), owner “perks”, travel/entertainment/meal expenses, automotive expenses such as monthly payments, gas, repairs, maintenance, license, etc., compensation to family members, rent expense not at market levels, etc..
**Treatment of owner compensation will vary depending on the size of company and the role played by the owners in day to day operations. In general, all owner compensation (whether below or above average) is included in ACF due to the primary investor motivation of “return on labor” rather than “return on investment”, i.e. a substantial portion of the overall return to ownership in a small, owner-operated business is in the form of salary and benefits. On the other hand, mid-size to large closely-held companies are associated with investor motivation that is primarily in the form of “return on investment” (whereby the normalized earnings or cash flow reflect the costs of attracting qualified third party executives or managers capable of performing the duties required by the company, i.e. to replace the current management which may or may not be part of the ownership).
***Treatment of interest expense will vary depending on the relevant measure of earnings or cash flow, e.g. interest expense is ALWAYS included in ACF due to custom (allows “apples to apples” comparisons and use of market comp data) and in net cash flow to invested capital (to capture flows to both shareholders and creditors; net of tax effect) but is NOT added back into net cash flows to equity (except as related to nonoperating assets).
Unusual, Nonessential or Nonrecurring Events*
- Adjust for gains/losses on the sale of assets/business segments, i.e. subtract the amount of the gain and add the amount of the loss due to their non-recurring nature
- Subtract the amount of insurance proceeds collected on a key man life insurance policy or a property/casualty claim
- Subtract the amount of funds received for settlement of a one-time lawsuit
- Adjust for the impact of a labor strike or an extended period of time in which certain key raw materials became unavailable
- Adjust for the impact of unusual, abnormal and non-recurring price fluctuations resulting from market or governmental forces
- Subtract from earnings or cash flow the benefits from utilizing a “net operating loss carryforward” in the period of use
- Add the “net operating loss carryforward” balance onto the economic balance sheet until it is utilized
- 8) Adjust for the one-time realization of revenues (and/or expenses) due to nonrecurring contracts i.e. subtract the amount of the revenue due to the increased revenue (netted by adding any expenses related to this one-time revenue generation)
- A one-time, Super Bowl related contract for a local security company in the amount of $1 million was removed from income due to its one-time nature
- Repair costs associated with a major freeze in a Phoenix, Arizona manufacturing firm were removed due to their unusual, non-recurring nature.
- Gains or losses associated with the sale of assets such as equipment, vehicles, etc., i.e. subtract the gain and add the loss to normalized earnings and cash flows.
- Adjust for charitable contributions (nonessential) in the amount of $5K
*It is important to recognize that the treatment of unusual or nonrecurring events will depend on the format of the firm’s income statement. Certain nonrecurring expenses will be listed in the “other income and expense” section of the income statement that follows the operating income result (EBIT) and others will be found inside the operating expenses above the operating income result. When calculating ACF, for example, the adjustment for nonrecurring expenses may be made either as an adjustment to operating income (or pretax income if the event was originally recorded in “other income and expense”) or as an “addback” in the final line of the typical ACF formula. Note further that due to the pretax nature of ACF, no tax implications arise in this case. If an after-tax measure of earnings or cash flow were being adjusted, however, there would be a tax effect (nonrecurring expense would increase pretax income and a nonrecurring revenue would decrease pretax income).
Non-Operating Asset-Related Expenses and Revenues
- Remove income and expense items related to rental property in Miami, Florida owned by an Illinois manufacturing firm.
- Dividends and interest income from marketable securities
- Remove excess cash from the balance sheet and subtract any interest income
- earned on the excess cash balances
- Remove marketable securities that exceed the reasonable needs of the business from the balance sheet. Dividend revenues/gains on sale of securities should be “backed out” of pretax income (and other measures) and losses on the sale of securities should be added back to earnings or cash flow measures
- Adjust for any real estate that is not utilized for operating purposes by adding back any related expenses (or losses related to sale of real property) and deducting any revenues (or gains related to sale of real property) into and from the pertinent measure of earnings or cash flow
- Adjust for all assets owned by the company but used in part or in whole for private/personal use, e.g. private jets, private collections, sports or entertainment facilities such as skyboxes, transferable season tickets contracts, vacation lodges, etc.
- Shareholder loans
- Adjust for prior period over- or under-payment of income taxes either in the current period or through restatement of prior year statements whereby the subject amount is spread out equally over the relevant timeframe
- Account for impact of “Built-In Capital Gains Tax” (so-called “BIG Tax”) to reflect underlying tax liability associated with unrealized appreciation of assets
- Adjust the earnings of an S-corporation (and Limited Liability Companies and Partnerships) for federal and state income taxes (profits of S-corporations are not subject to taxation, i.e. they are “pass-through” entities whereby taxable income “passes through” the corporation to the individual shareholders)
- Actual cash taxes versus deferred taxes.
*While many types of adjustments will impact restated or normalized pretax income (and hence after-tax income), this category generally refers to specific tax-related issues such as tax affecting S-corporation earnings or adjusting for timing differences between financial statement income and tax return income (profit).
Accounting Policy/Procedure-Related Issues*
- Expensing of qualified assets for tax purposes (and by choice book purposes) per IRS Section 179 despite a useful life of five years or more, i.e. restate both earnings/cash flow and fixed assets to reflect underlying reality.
- Amortization or deferral of revenues/expenses over the life of an asset or project that may not reflect the underlying economic activity
- Transform cash basis accounting statements into accrual basis financial statements for purposes of comparability and valuation of equity.
- Restate total revenues to reflect intentional delay of revenue recognition at year-end for tax purposes (must also account for “spillover” effect from prior year).
- Restate total expenses to reflect accelerated payments of certain expenses such as rent expense at year-end for tax purposes
- Adjust for changes in inventory pricing/costing, e.g. a change from LIFO to FIFO in order to restate financial statements in line with industry norms (improved comparability for financial statement analysis)
- Adjust for changes in depreciation method to reflect industry norms and enhance comparability i.e. changing from depreciating assets on a straight line basis to an accelerated basis or vice-versa
- Restate fixed asset balances by changing historically expensed asset acquisitions into capitalized assets, e.g. changing prior period Section 179 expenses into capitalized and thus depreciated fixed assets (impacts both income statement and balance sheet)
- Adjust for changes in revenue and expense recognition methods i.e. changing the way long-term, multi-period contracts, installment sales, warranties, and subscriptions are accounted for to match industry norms and improve comparability for both financial statement analysis purposes and for purposes of applying the Guideline Public Company Method
Note: remember that the normal “adjustment procedures” related to use of the market approach method called “Guideline Public Company Method” normally involves the modus operandi of “always adjust to the subject firm”, i.e. it is preferable to adjust the accounting procedures of the guideline companies to match the subject firm’s policies rather than the other way around.
- Adjust inventory to current market values, i.e. “write-down” book values to market values to reflect obsolescence, slow moving stock and “shrinkage” due to damage or theft (the asset inventory is reduced and pretax profit is reduced due to related “loss”).
- Account for unrecorded assets or liabilities (so-called “off-balance sheet” items) to transform accounting balance sheet into economic balance sheet
*These adjustments revolve around comparability issues stemming from GAAP-related choices between one accounting procedure and another and timing differences associated with the recognition of expense and revenue events.
- Locate all “off-balance sheet” assets and liabilities to complete the economic balance sheet, e.g. fully-depreciated assets, contingent liabilities**, etc.
**This category of adjustment (probable and estimable liabilities) is far-reaching as the list below indicates:
- Potential environmental liabilities/cleanup costs
- Product warranty or service liabilities
- Unrecorded pension plan liabilities
- Impairment of fixed asset values
FASB #5 states that any contingent liability which is both probable in occurrence and reasonably estimated must be included in the financial statements. Due to the preponderance of “compiled” financial statements for private firms, the valuator must attempt to determine whether or not any such liabilities exists; if so, both the liability and the offsetting expense/asset must be accounted for in the normalization process.
- Account for favorable lease rates, i.e. estimate present value of future below market rental payments and record as asset (example of off balance-sheet asset)
*These adjustments are unique and not readily classified into one of the five main categories utilized above.
The ACF Framework/Owner Compensation Considerations
The “Adjusted Cash Flow” Framework
Prior to formally categorizing the “types” of adjustments normally included in the normalization process, it is worthwhile to discuss the widely-used “adjusted cash flow” framework applicable to privately-owned firms of both the business brokerage and middle-market segments. Although most applicable to the smaller private firms (more precisely private firms wherein the owner is a major contributor to the day to day activities of the business operations), this “generally accepted” framework may also be used for middle-market firms (and in fact should be used in certain situations) of substantial size and even passive or absentee ownership.
A discussion regarding terminology is in order here due to the wide variety of terms used to describe what is essentially the same concept or framework. What we refer to as “adjusted cash flow” (see Gabehart’s “The Business Valuation Book”, published by Amacom Publishing in 2002) goes by many different names such as:
Comparable Terminology for Adjusted Cash Flow
Seller’s Discretionary Cash or Seller’s Discretionary Cash Flow
Owner’s Cash Flow
Irrespective of the title attached to this measure of earnings, its content is remarkably consistent from one application to the next. It is most instructive to consider ACF as more than a simple measure of earnings; rather it is a framework for evaluating the financial benefits generated by a small business for its ownership. Specifically, ACF is interpreted as:
“The pretax, cash equivalent financial BENEFITS accruing to a single owner working a business on a full-time basis”
As such, it represents an attempt to account for many of the “normalization” adjustments applicable to the transformation of GAAP-based, tax minimizing income statements into a more useful measure of earnings. Despite its widespread usage and nearly universally consistent interpretation, it is not a comprehensive measure of “normalized” earnings as we shall soon discover. For better or worse, this specific measure of earnings is used by business brokers, buyers and sellers, CPA’s, bankers and even professional business valuators when evaluating the earnings generation of the small, private firm. As noted earlier, it is most typically used for smaller, business brokerage segment businesses wherein “the owner is the business” or whereby the business would not be as productive as it is without the contributions of an owner.
Because the major market comp databases such as Bizcomps, the IBA database and even Pratt’s Stats presents their transaction data in part based on a multiple of “adjusted cash flow” (or whatever term is used to describe this specific measure of private firm earnings), it is even applicable to substantial middle-market firms in many instances. The success of this particular measure is due to its role in facilitating “apples with apples” comparisons of business opportunities moreso than its theoretical supremacy.
Arguments abound as to why it is not an optimal measure of earnings or cash flow, e.g. it does not account for planned capital expenditures or working capital investments or even taxes. This measure has simply served to fill the void associated with GAAP-based income statement earnings measures while facilitating the consistent estimation of business value among privately-held firms.
Adjusted cash flow is typically calculated as the sum of “pretax income” plus a series of “addbacks”, making it a “pretax” measure of small firm earnings. The specific components are:
+ Owner Salary/Payroll Tax
+ Owner Benefits
+ Depreciation/Amortization Expense
+ Interest Expense
+/- One-Time, Non-Recurring Expenses/Revenues or Losses/Gains
Adjusted Cash Flow
Taken full circle, this figure may also be interpreted as:
The pretax, cash equivalent measure of financial RESOURCES available to a new owner to use as desired, i.e. to service debt, pay an owner salary and hopefully earn a positive return on invested cash.
As the ACF formula above illustrates, it contains a series of “adjustments” related to the process of “normalization”, i.e. it represents a partial transformation of GAAP-based, tax minimizing income statement associated with the typical privately-held firm. In short, it transforms “pretax income” (GAAP-basis) into a more complete measure of private firm cash flows by incorporating the owner’s compensation, non-cash expenses, debt-related costs and “extraordinary” revenues/gains and expenses/losses (all of which are so-called normalization adjustments).
Because ACF does not incorporate ALL potential normalization adjustments, however, it is incomplete from a thorough and theoretically correct perspective. In other words, it does not measure the amount of cash flows which are available to the ownership after ALL of the company’s operating needs have been met (only a measure such as net cash flow to equity or invested capital that is also “normalized” can truly capture the firm’s “true” earnings-generating capability).
On the other hand, because it is so widely and uniformly applied by market participants and because the comparable sales method (also called Direct Market Data Method) relies in large part on multiples of ACF, it is a de facto relevant and powerful tool for assessing private firm value (specifically fair market value on a going concern basis). It should be stressed once again that the ACF framework is MOST applicable to the smaller, owner-dependent private firms but also can (should) apply to middle-market firms when the comparable sales method is utilized.
Note that due to the inclusion of interest expense, ACF is somewhat similar to the “net cash flow to invested capital” perspective, i.e. it is “debt-free” or “debt-neutral”. In other words, it allows the estimation of “business value” prior to consideration of how the business operations are financed (the “available” cash flows include whatever funds were devoted to interest expense). Because each buyer may choose to finance a business in whatever manner deemed appropriate, the value of a business should not depend on any specific capital structure (a particular combination of debt and equity financing).
In the pursuit of full disclosure, another shortcoming of the ACF model would be the exclusion of the payment of principal associated with the included interest expense. If the goal is to account for all of the ongoing financial obligations/investments/needs of a given business, funds which are diverted towards the repayment of debt (principal) should also be accounted for (but alas they are not).
Despite the shortcomings alluded to above (and others not mentioned), a full and proper understanding of this “framework” is essential to effective value estimation of many privately-held firms. Even the commercial banks rely in large part on this measure of “income” or “earnings” or “cash flow” of “benefits” or “resources”, with one major difference. Many SBA lenders will calculate the traditional ACF figure (as per the formula presented earlier) for purposes of evaluating acceptable “debt service” ratios. The difference, however, involves the subtraction from the normal ACF result of the new owner’s (borrower’s) living expenses. Accordingly, the banks conservatively utilize a lesser cash flow figure to calculate the “cash flow to debt service ratio” in accordance with pertinent policies and guidelines.
In conclusion, the ACF (or SDC or OCF or DE or Net) figure plays a central role in small firm valuation due to its “general acceptance” and “uniform application” across all types of businesses. The appeal of this framework is found in its simplicity and consistency and its routine incorporation of many of the common “normalization adjustments” that are necessary for effective and credible valuation analysis. Depending on circumstances, it may or may not be proper to end the normalization process with the determination of ACF, i.e. it is often necessary to further adjust the ACF figure due to other types of normalization requirements.
ACF versus Net Cash Flow to Equity/Owner Compensation
As just described, the ACF framework is a widely-used cash flow measure comprised of pretax income plus a series of “addbacks” (many of which represent the most common types of normalization adjustments, e.g. including owner compensation and one-time, non-recurring revenues/expenses/gains/losses, etc.). Despite the fact that ACF is not a measure of “earnings” or a “fully normalized cash flow” figure, common practice dictates its frequent usage for many privately-held firms (both within the Income Approach and the Market Approach).
One of the more volatile and confusing components of normalized earnings and cash flow measures concerns the treatment of owner compensation. Depending on circumstances, it may be prudent or necessary to include ALL owner compensation or NO owner compensation whatsoever. The determinants of whether ALL or NO owner compensation is incorporated into an earnings or cash flow figure depends in large part on the following factors:
- Which measure of earnings or cash flow is being utilized
- Which valuation method is being utilized
- Nature and role of the owner’s participation
- Environment within which similar businesses are bought and sold
- Valuator judgment
- Purpose of valuation
The most basic and consistent situation involving the treatment of owner compensation is the ACF framework. By definition and by common practice, ACF includes ALL OWNER COMPENSATION (salary, payroll tax, perks). There is no debate or judgment involved here; in every case the full amount of owner compensation is included for a single owner working full-time, period. If multiple owners are working or the business is run on an absentee basis, adjustments must be made to bring the figure to a “full-time, single owner-operator” basis.
Why is the entire amount included in ACF? The best answer involves understanding the environment within which smaller private firms are bought and sold. For businesses that are typically purchased by “financial buyers” (buyers who plan on working the business full-time to earn a salary and hopefully a return on investment), the relevant “returns” include the owner’s salary and benefits. As such, it is proper to speak of the buyer/owner “return on labor” as opposed to a “return on investment”.
In the case of larger, middle-market firms, the buyer may be either a financial buyer or a strategic buyer. In either case, the buyer/owner may or may not replace the exact role played by the selling owner, i.e. it may be that a general manager or CEO might be hired to operate the business (either to compliment the new owner’s activities or to fully take charge in operating the business while the new owner acts as a more or less passive investor). In this situation, the relevant return is more properly stated as “return on investment”.
In short, the difference between “return on labor” and “return on investment” involves the role played by the new owner. If the new owner will become actively engaged in the operation of the business, his total returns will include both the salary and benefits as well as the traditional return on invested cash. If the new owner will remain passive and hire a replacement general manager, the relevant return is “return on investment” AFTER accounting for the cost of hiring a replacement management team.
In the “return on labor” situation, the full amount of owner compensation (salary and benefits) is included in the relevant measure of cash flow for valuation purposes. In the “return on investment” situation, only “excessive” or above market compensation is to be included in the relevant measure of earnings or cash flow, i.e. it must account for the “cost of management” that will be hired to operate the business. These excessive salary/benefit payments are essentially hidden operating profits and represent a “return on capital” moreso than a “return on labor”.
In regards to the normalization steps related to owner compensation, the ACF application is quite straightforward (all owner compensation is added to pretax income and other “addbacks” in reaching ACF). In regards to the middle-market, return on investment perspective, the most common step involves the “restatement” of the actual owner compensation to a “market level” compensation (only the excessive or above average compensation remains as part of the relevant earnings or cash flow figure), i.e. the cost of replacement management is subtracted from the actual owner compensation, leaving only the excessive portion as earnings or cash flow.
Note that a similar adjustment is made if the owner compensation is “below market levels”, i.e. the shortfall in compensation is imputed as an additional cost of operations/management. The underpayment of owner compensation is likely to occur in situations where the subject business is “underperforming”, whereby the low or nonexistent salary serves to increase the reported level of profits.
In practice, one of the most misused areas of accounting for the closely held firm involves owner compensation. Compensation is often based on non-business motivations and therefore over- or under-stated. By comparing to industry norms (trade associations, industry financial information resources, US Department of Labor, www.salary.com, etc.), compensation can be “adjusted” upward or downward as necessary to reflect market levels. The offsetting adjustment is often made to the owner equity section of the balance sheet (increase or decrease in distributions to owners/dividends).
The topic of owner compensation is multi-faceted, requiring different adjustments in different settings (as described earlier). For tax purposes, the IRS addresses the concept of owner compensation in relation to “normalized earnings” in Revenue Ruling 68-609 (updated restatement of ARM 34, the 1920 IRS document which put forth the “excess earnings method” for the valuation of impaired goodwill due to prohibition), stating that:
“If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business”
Another area of interest in regards to taxation concerns C-corporations. Due to the “double-taxation” of C-corporation profits, this type of entity and its owners will benefit from overpayment of salary as compared to payment of dividends. By increasing the share of “income” in the form of salaries relative to dividends, the corporate taxable income is reduced as income is “shifted” towards “personal income” at personal income tax rates. Note the following simple example:
Total C-Corporation Pretax Income and Owner Salary $1,000,000
Total Payments to Owner (Either Dividends or Salary) $500,000
Salary and Dividend Payments
Salary Payments $300,000
Dividend Payments $200,000
Corporate Income Taxes $273,000 ($1M - $300K)(39% Corporate Tax Rate)
Individual Income Taxes $165,000 ($500K)(32% Personal Tax Rate)
Total Tax Obligation $438,000
Salary Payments $500,000
Dividend Payments $0
Corporate Income Taxes $195,000 ($1M - $500K)(39% Corporate Tax Rate)
Individual Income Taxes $165,000 ($500K)(32% Personal Tax Rate)
Total Tax Obligation $360,000
Accordingly, a total of $78K is saved in total tax payments under the “excessive salary” scenario. In general, the greater the salary excess and the greater the difference between corporate and personal income tax rates, the greater the tax savings.
The precise determination as to what is considered excessive compensation is clearly a matter of opinion. The general goal is to establish what a reasonable salary would be for the exact services performed by the owner. Theoretically, this would involve the evaluation of the owner’s education, knowledge, experience, skills, duties and responsibilities, hours worked at the business, general business environment, business structure, industry practices and of course the package of benefits provided to the owner.
A landmark court case (L&B Pipe and Supply Company v. Commissioner; Tax Court Memo 1994-187) dealt with “reasonable compensation” and resulted in a list of factors that the court considered relevant for their determination:
- Manager’s Role
Comparison of Compensation in Similar Situations
- Hours Worked
- Duties Performed
- Importance to Company Success
What did similar owners/employees earn in similar firms for comparable services?
Condition and Character of the Company
Possible Conflicts of Interest
Was there a relationship between the company and the employee that permitted "disguising" nondeductible corporate distributions as salary?
Were bonuses awarded in a formal and consistent manner not based on a percentage of the employee’s stockholdings?
The court concluded that:
“A formula should reasonably compensate for the work done, the performance achieved, the responsibility assumed, and the experience and dedication of the employee, while at the same time allowing investors a satisfactory return on equity…..”
Nonoperating Asset Discussion
Another interesting article geared towards normalization and working capital assessments is found in the Winter 2000-2001 edition of Business Appraisal Practice called “Treatment of Non-Operating Assets With a Focus on Excess Working Capital” (by Kenneth W. Patton, ASA).
The author bases his analysis on the premise that the success of closely-held businesses over the past ten years (prior to the recent recession) had increased their absolute size and led to an accumulation of significant “liquidity” (or alternative investments). He clearly defines nonoperating assets as:
“Assets which can be IDENTIFIED and SEPARATED from the business WITHOUT ANY IMPAIRMENT in the business’ operating results or the financial position necessary to operate the business.”
He rightly notes that this definition is quite simple but the actual quantification and application within the valuation process is not. As is common throughout the valuation effort, judgments must be made and reasonable people will disagree as to what is a proper adjustment. Examples of nonoperating assets include:
- Cash or Other Liquid Investments
- Land or Buildings (which have no present or future use in the business)
- Cash Value of Life Insurance
- Partnership Investments
- Loans to Officers or Shareholders
- Excess Working Capital (invested in accounts receivable, inventory or reduced levels of accounts payable)
Many of the earlier “authoritative” sources addressed the first five items above in detail. Many also addressed “excess” assets such as cash or inventory (treated individually), but did not cover the whole of working capital in terms of nonoperating assets. Typical appraisal procedures will routinely uncover the first five items above (questionnaires, discussions with management/CPA, tour of premises, etc.), but the working capital item is different (according to the author) because management has invested funds in operating assets (such as receivables and inventory).
Common tools for assessing working capital adequacy include comparisons with peer groups (common size data for same SIC code and similar size operations), with any difference representing the excess or deficit of working capital. The author notes that there are significant limitations to this tool, including:
- Peer data rarely represents the full industry
- Detailed financial and operating policies and procedures of the companies in the peer group are almost never disclosed
Another challenge involves the fact that the necessary or optimal amount of working capital in a given firm will vary according to several qualitative and quantitative factors, e.g. terms of sale and purchases as well as inventory turnover. Not every company will require the same amount of working capital (especially when receivables, inventory or reduced levels of payables comprise the bulk of this amount), contradicting the basis for using peer group data for the determination of “excess” or “deficit” amounts.
Auto dealerships have been increasing cash and equity in order to obtain preferred borrowing rates for their inventories and construction firms have done the same in order to meet bonding requirements for larger contracts. Prior to eliminating an asset from the accounting financial statement for valuation purposes, the following questions should be answered:
- Does elimination of the asset leave the business with adequate equity from the perspective of outside parties, e.g. will vendors maintain the same credit terms?
- Does elimination of the asset violate loan agreements? Many agreements have covenants that require minimum levels of equity and working capital, which cannot be met without all the assets of the business. The banker’s view of which assets are nonoperating may be significantly different than the owner’s or the appraiser’s views.
- The asset may be pledged as collateral and is not separable from the company.
- Dividend restrictions may be present in loan agreements, which preclude high dividends in any given period of time.
The questions above illustrate the dynamic interrelationships between liquidity, equity and operating income.
The courts, on the other hand, have relied on relatively objective approaches such as current ratio analysis, capital needed to meet operating expenses in a given year and surplus ranging from 2/3 to ¾ of annual operating costs. The landmark “Bardahl” case established an objective formula for calculating the amount of working capital required for one operating cycle.
Above all else, this informative article emphasizes the importance of truly understanding the subject company’s operations, its industry and its investment strategies prior to making adjustments of this type, i.e. try to avoid the simplistic financial and business analysis often seen in calculating excess working capital (or simply excess cash or inventory).
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