Who else could use some normalization right now?
July 13, 2020
By Martha Sullivan
Normalization. What a word. What a concept! Especially these days.
Many of us are trying to decipher what normal looks like, especially if we are planning for the future of our businesses. If you are looking to understand the current value of your business, the question is similarly vexing. Where's the crystal ball when you need one?
When determining the value of our businesses, there's a part of process called "normalization." It is a fundamental component of any value calculation analysis. This is the part of the process where the less-than-normal elements are adjusted for in the analysis of historical results, generally by adding or subtracting the adjustments from the bottom-line earnings before interest, taxes, depreciation, and amortization (EBITDA). These adjustments could be anything from a one-time windfall, like payment of an insurance claim, or a one-time, special expense such as professional fees associated with a legal matter. Adjustments are also made to account for owner-discretionary items such as what an owner's compensation or the building rent might be if subjected to market rates rather than the discretionary levels set by the owners. The analysis will also remove owner-specific costs run through the business. The normalized, adjusted financial results are then used to calculate the value of the business based upon its risk profile, discount, and cost of capital rates and other factors.
That all is well and good in valuation theory, but what happens when there is no normal? What happens when the past, even as recent as seven months ago, is only a faint memory? Is the "baby tossed out with the bath water"? Does the historical analysis become irrelevant? Does all that work and success count for nothing, regardless of whether the business is currently experiencing either a downturn or uptick?
The good news is the answer is "No. Your history still matters" The bad news is that it comes with a caveat of "It depends." Regardless of whether your company is currently diving or thriving, your understanding of why the business is doing what it's doing and whether it is sustainable will drive how relevant the historical data is.
For example, if you are in the cruise business, your prior history will be a very suspicious predictor of near term (as in maybe two years???) results. If you have an amazing balance sheet and a swift mind, you may be able to hang in there with serious adjustments. Regardless, the value is going to be based on a future view rather than historical. Normalization analysis will be needed throughout the entire set of financial statements rather than simply unusual and discretionary expenses.
On the flip side, perhaps your business is going gangbusters because you have been able to expand your product lines and/or volume - similar to how some adult beverage manufacturers have branched into manufacturing sanitizer, adding new sales on top of the recreational-therapy induced increase in beverage sales. Or maybe you make bikes and have always made bikes. But now the demand for bikes is off the charts since we are limited in our more socially oriented activities.
Normalization in these cases will also be future-focused and need to address questions such as is the increase in demand a one-time blip, like in the case of the bikes, that will eventually settle back down? Is the beverage company prepared to make the product line extension permanent or was it simply being a good corporate citizen in the face of a crisis? If it's permanent, it's one thing and should be factored into the assumptions for the going concern. If it was good citizenry, then it should be factored out and removed from the analysis to present a more accurate picture of "normal."
While normalization is a part of any valuation process, it should also become a part of your routine planning and cashflow management process. Now is the time to up your game in that regard so you are in a better position to make the critical decisions you need to every day. Decisions made today directly impact your prospects for survival, growth, and business value tomorrow.
Some ways you can factor it in include:
- As you maintain your 13-week rolling cash forecast, consider the volatility you may be experiencing and how likely is it to remain as such for the next four, eight, and 13 weeks?
- What expenses are spiking or are artificially depressed? Have you instituted layoffs or across-the-board pay cuts to conserve cash? How long do you anticipate that continuing? Use what-if techniques for what it would look like to determine when you might adjust back to the previous normal or a new level and approach for staffing and other expenses.
- What would the bottom line look like if owner-discretionary expenses did not flow through the business? This may be important if there are challenging conversations on the horizon with the bank. Note, many business owners do not run personal expenses through the company, preferring a more definitive line. However, for those business owners who do, you're able to think this calculation through.
- Envision that new normal. What other elements and factors should be integrated into or adjusted out of your data? What should be included in a projection of the future?
For those readers that do not have a formalized 13-week rolling cashflow or business plan, we need to talk ASAP. Strategic planning is no longer optional, nor it is still looking out three to five years. Right now, strategic planning may be a max of two years, depending on your situation. (Heck, it might feel like two weeks is strategic!) Having and working a plan is vital in times like this and, in fact, can help things return to feeling "normal."
And that is how you do normalization.