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Business Appraisal

Business Appraisal · Folios

Folio 3 · Earnings

Normalising earnings

Normalising earnings, as this guide uses the term, means adjusting a year’s recorded profit so it shows what the business earns in an ordinary year, with every dealing at arm’s length. It matters because income-based methods start from profit: business.gov.au’s return on investment formula, for one, uses net profit directly.

General information, not financial, tax or legal advice. This page explains how valuation works; it does not value any business. For your own situation, check the ATO, business.gov.au or ASIC Moneysmart, and ask a qualified adviser.

A made-up profit, adjusted, with the result enlarged Example only, made-up figures. Net profit as recorded $110,000, add-backs $15,500, deductions $72,000, normalised profit $53,500, enlarged by a loupe. EXAMPLE ONLYAMOUNT03Net profit as recorded$110,000Add-backs+ $15,500Deductions- $72,000Normalised profit$53,500 EXAMPLE ONLYAMOUNT03Net profit as recorded$110,000Add-backs+ $15,500Deductions- $72,000Normalised profit$53,500
A worked example with made-up figures, set out in full below. It ends at a profit figure, never at a value.

iThe sequence

Seven steps through the accounts

  1. Start from the profit and loss statement

    A profit and loss statement lists sales and expenses; net profit is what is left after expenses are subtracted from sales. business.gov.au asks that estimated costs be clearly labelled, and that the statement say whether figures include GST.

  2. Gather more than one year

    business.gov.au suggests having financial statements for the last 5 years if possible when valuing a business, and its advice to buyers covers three to five years of figures, from tax returns and business activity statements to profit and loss records.

  3. Separate private spending from business spending

    Among the errors the ATO commonly sees are owners using company assets for private purposes, and using a single bank account or card for private and company expenses, which makes the two hard to tell apart. A company is a separate legal entity; its money is not the owners’. Private costs that went through the business are one adjustment.

  4. Mark the items that will not happen again

    A valuation rests on what is known, or could reasonably be foreseen, at the valuation date. A cost that belonged to one unusual event says little about an ordinary year, and an unusual windfall says just as little in the other direction.

  5. Price related-party dealings at arm’s length

    The ATO’s guide gives landlord and tenant as an example of a relationship that can push a price away from the market. Rent paid to the owner’s family, wages paid to relatives, or supplies bought from a connected business can all sit above or below what strangers would agree.

  6. Count the owner’s own work

    If the owner works in the business, ask whether the accounts include a cost for that work. A buyer who does not do the work themselves would need to pay someone who does.

  7. Write every adjustment down, with its reason

    The ATO expects judgements in a valuation to be transparent, with inputs and assumptions stated, and it lists unverified inputs and unreasonable or incorrect assumptions among the problems it commonly finds.

iiWorked example

A worked example, with made-up figures

Example only

Every figure here is invented to show the arithmetic. None of them describes a real business, an industry, a typical wage or a typical rent.

Example only: made-up figures, computed line by line.
LineTreatmentAmount
Sales for the yearAs recorded$520,000
Expenses for the yearAs recorded− $410,000
Net profit as recordedSales less expenses$110,000
Private car and phone costs paid from the business accountAdded back+ $6,500
One-off legal costs for a lease dispute that has endedAdded back+ $9,000
The owner’s full-time work, with no wage recorded (an assumed cost for this example only)Deducted− $60,000
Rent below a market rent, because the premises belong to a family trust (an assumed difference for this example only)Deducted− $12,000
Normalised profitRecorded profit, plus $15,500, less $72,000$53,500

What the example shows

The adjustments ran both ways. Two items made the recorded profit look smaller than an ordinary year’s, and two made it look larger. In this made-up case the deductions outweighed the add-backs by $56,500, so the normalised profit came out at $53,500 against $110,000 recorded.

The two deductions are the ones built on assumptions, which is why each needs its reason written beside it. A different assumed cost for the owner’s work, or a different market rent, changes the answer directly.

Where the example stops

It stops at a profit figure on purpose. Turning profit into a value means choosing a method and the rates or multiples that go with it, and the ATO lists unsupported adjustments to the discount rate or capitalisation multiple among the problems it sees in valuations. That step belongs to a qualified valuer working on the real business.

iiiOver the years

One year is a snapshot

business.gov.au suggests estimating future profit from trends in past years’ finances, and from trends in similar businesses. The ATO lists the inappropriate use of averaging, and proxies based on historical performance, among the issues it commonly finds. A run of normalised years shows a direction; a single average can hide it.