To establish the business profitability potential, you may need to make some normalizing adjustments to the income statement. There are a number of items that frequently require adjustment.
Owners compensation adjustments
Adjust total owner compensation to the market rate of hiring a manager replacement. Note that the total owner compensation includes the owner salary, bonuses, profit sharing payouts and benefits. Adjust the working family and friends’ compensation to the market rate required to hire a replacement to perform the same function.
Regardless of the depreciation method used, you may need to adjust the depreciation expense to match the true economic value of the business assets.
If inventory accounting is reported on the LIFO basis, convert it to the FIFO basis. Simply add back the LIFO reserve which should be available from the financial statement footnotes or the company’s CPA. The FIFO inventory reporting accurately reflects the company inventory costs and is a preferred choice when assessing gross margins.
Business rental expense adjustments
Adjust rents to the fair market rent values. This is important if recorded rent expense is above or below market rates. An example is the business owner renting personally owned property back to the business at above market in order to minimize the taxable income.
Adjust out any non-recurring items
- Factor out the effect of any business interruptions. An example is when the business operations are paused due to facility repairs.
- Factor out amounts from insurance claim proceeds and lawsuit settlements.
- Eliminate any one-time gains or losses from the disposition of assets. An example is selling autos or company owned real estate.
- Exclude gains or losses from business operations that have been discontinued. An example is a closed retail unit.
- Remove abnormally high or low profits. An example is high profit margins due to a temporary spike in demand.
- Factor out one-time expenses such as the business moving expenses.
Include the actual or potential business expenses that have not been recorded:
- Unrecorded accrued expenses. Examples are staff vacation or bonus pay.
- Check and adjust for bad debt expenses. Examples are uncollectible accounts receivable – check the receivables aging report.
Adjustments for expected future changes
Factor in any potential changes such as an expected loss of a key customer. This should be accounted for in your cash flow projections.
Handling non-operating income and expenses
Remove non-operating income or expense. Examples are non-business real estate income or expenses.