Valuations - Why normalising earnings is so important


A current valuation is essential for many SMEs, and the capitalisation of future maintainable earnings approach, for many, is the most appropriate way to value the business.

An accurate assessment of current value can be required at any time but is essential when there is a restructure, potential sale or an investment in the company.

Net profit should not be confused with normalised or maintainable earnings. They are quite different. Normalising earnings can often lead to a higher valuation than a simple net profit assessment. That higher valuation can have a significant impact on an SME owner's wealth, including their retirement plans.

For SMEs, typically, there is a focus on tax when the annual financial statements are produced.

But when a business is being valued it is the true accounting profit that is more important. Normalising earnings uncovers the real maintainable earnings of a business.

It adjusts earnings for abnormal or non-operating costs, interest and expenses incurred which are at the discretion of the owners. These can have a substantial effect on net profit. Bad debts, legal costs, or the hefty cost of the launch of a new product, can markedly lower profit levels for an SME. All deductible expenses but not necessarily a reflection of the business on a normal operating basis. Similarly above market owner remuneration or expensive motor vehicles can reduce profits and, on the surface, dilute value.

Provisions may not have been taken up in the accounts but will be adjusted for in a valuation and depreciation is another crucial area. Most SMEs use the highest depreciation rate allowed by the Australian Taxation Office, and in recent years this has been quite generous including the instant asset write off allowances.

Writing off assets in the year of purchase can be great for tax purposes, but it also artificially reduces profits. Accelerated depreciation leads to an artificial reduction in the true profit of the business, which can impair the valuation of the SME. All of this is adjusted in the normalisation process and may add hundreds of thousands of dollars to business value.

A valuation needs to ascertain the real earnings of a business. Normalising earnings should lead to an accurate valuation of the business, rather than one which is based purely on the net profit disclosed in your financial statements.

Hayes Knight has experts who can assist at all stages of the valuation process.

Contact us here to schedule a valuation with our experts.