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 manager’s 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 year’s EBITDA.
What Are Normalizations To Cash Flow And How Do They Affect Value
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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
Zenith Manufacturing
$1,500,000
4.0 x
$6,000,000
e
f
g
e+f+g = h
a+h = i
b
ixb=j
j-c
$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 owner’s 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
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ABOUT EQUICAPITA
Equicapita is a private equity fund that acquires established, private, small and medium sized
enterprises (“SMEs”) located primarily in Western Canada. Equicapita’s 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.
DISCLAIMER
The information, opinions, estimates, projections and other materials contained herein are provided as of the
date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections
and other materials contained herein have been obtained from numerous sources and Equicapita and its
affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources
believed to be reliable and to contain information and opinions which are accurate and complete. However,
neither Equicapita nor its affiliates have independently verified or make any representation or warranty, express
or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein
or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions,
estimates, projections and other materials contained herein whether relied upon by the recipient or user or
any other third party (including, without limitation, any customer of the recipient or user). Information may be
available to Equicapita and/or its affiliates that is not reflected herein. The information, opinions, estimates,
projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for
or an offer to buy, any products or services referenced herein (including, without limitation, any commodities,
securities or other financial instruments), nor shall such information, opinions, estimates, projections and other
materials be considered as investment advice or as a recommendation to enter into any transaction. Additional
information is available by contacting Equicapita or its relevant affiliate directly.
What Are Normalizations To Cash Flow And How Do They Affect Value
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