by Gabriel Andrada, MHA, CSAF, CHBC, CVA
In valuation, “normalization adjustments” are the adjustments made to reported financial statements to better understand the true financial and operating performance of a business for investment purposes.
Normalization adjustments may include the elimination of non-recurring or non-operating income or expense items, the removal or normalization of owner discretionary items (including officer compensation and related party transactions), or adjustments to accounting entries (such as accelerated depreciation, prior period adjustments, journal entries, etc.).
In some instances, it may also be appropriate to make run-rate adjustments to reflect the anticipated full year impact of mid-year changes. For example, if a new physician is hired mid-year, that physician’s patient volumes and revenues will be understated for that year and should be annualized to reflect the anticipated full-year volumes. Similarly, that physician’s compensation will also be understated and should be adjusted to reflect the full year cost of salary and benefits.
In larger, more complex transactions, the normalization process may be conducted as a more rigorous, standalone process. This process, referred to as a Quality of Earnings (QofE) analysis, is a detailed analysis of a company’s financial and operational data that provides additional assurance that the EBITDA is sustainable. Procedures performed in connection with a QofE analysis may include:
- Revenue Testing
- Revenue to cash reconciliations / comparison of financial reports (e.g., internal financials, tax returns, etc.)
- Review of charges and collections trends by payor class, identification of trends, review/discuss historical and pending contractual agreements
- Preparation of cash waterfall schedules by payor class / presentation of accrual revenue estimates
- Normalization of non-recurring events / go-forward changes
- Expense Testing and Normalization
- Review and discuss expense policy, discussion of use of estimates/allocations
- Trend analysis (% of revenue, $/unit)
- Comparison of reported expenses to key contracts (e.g., rent, equipment leases, service contracts, etc)
- Cash to accrual estimates
- Normalization of non-recuring items / go-forward changes
- Working Capital Analysis
- Review of accounts receivable aging by payor class over time
- Analysis of collection ratios and bad debt policy
- Review of reported current liabilities
- Prepare estimate of required working capital
- EBITDA Run Rate analysis
- Testing of Balance Sheet items
In short, normalization adjustments allow the appraiser (and investor) to better understand and measure the true financial position of a business. Normalized earnings are the measure that should be used for valuation purposes including the application of a valuation multiple or as the base year in a financial forecast.
At Root Valuation, we help physician leaders successfully navigate business and employment transactions to that their value is fully realized. Have a question about your business valuation, contact us at email@example.com or speak with Gabriel Andrada at 720.634.7025.