Understanding the value of your business is critical to many decisions you will make as a business owner, from securing capital and succession planning to liquidity events or sale of your company. Earnings and cash flow to owners increase your business value. In the view of lenders, investors, buyers, shareholders and board members, the concept of “normalized” and “sustainable” earnings are a key metric when assessing it.
Normalized earnings is a concept that looks at recent and imminent performance to project future earnings of a company. It is commonly used to give decision makers a realistic look at a business’s ability to service debt, make capital expenditures, take on new projects or products, pay dividends, and make distributions. Normalized earnings can also aid in the process of budgeting and benchmarking and is a key concept in business valuation (valuation in a general sense, not only for formal business valuation reports).
A common technique to normalize earnings is to develop a weighted or simple average of the business’s latest-twelve-month (LTM) earnings and the average earnings of the previous three to five years. Frequently the calculation places a heavier emphasis on more recent periods (e.g., 40% LTM, 30% prior FY-1, 20% prior FY–2, 10% prior FY-3). An expected or budgeted fiscal year might also be utilized, especially in a turnaround year.
This approach seems simple enough, but this process needs to consider any anomalies in performance in the recent past and immediate future. For example, normalized earnings during the Covid-19 crisis would have yielded far from “normal” results for many companies.
Consider Peloton’s drastic revenue fluctuations during the pandemic. After the company’s earnings skyrocketed fourfold between 2019 and 2021, it experienced revenue drops in the billions as pandemic restrictions relaxed and consumer demand for in-home fitness equipment subsided.
Other businesses encountered unprecedented swings in earnings in the opposite direction, as their business operations were suddenly shut down. Their LTM and three- to five-year averages will not be indicative of their future performance. Other factors that could influence the effectiveness of normalized earnings include inflation, supply chain disruption, staff shortages and volatility in input costs (e.g., permanent or temporary increases in ingredient costs, fuel, labor, transportation, etc.).
When calculating normalized earnings, you should also identify known scenarios that could impact future revenues, such as a high concentration of earnings from one or two customers. Losing that customer would have dire consequences on your bottom line and should be taken into consideration when making business decisions based on this data.
Looking at normalized earnings is particularly effective when a small or mid-sized business has reached a certain level of maturity but does not yet prepare budgets or forecasts. This approach, however, is not appropriate for rapidly growing companies because they have not achieved “normalcy” yet, and their past performance is not the best indicator of the future.
As mentioned, it is important to understand your business’s normalized earnings because other stakeholders and third parties are looking at them too. Lenders use the calculation to determine how much debt the company can service, and what terms and covenants will be associated with those loans. Potential buyers look at normalized earnings to determine a target company’s value and structure a purchase offer. Investors will also use them to estimate a rate of return, while valuation firms rely on them for gift tax returns and shareholder disputes or buyouts.
Remember, value is ultimately in the eye of the beholder, and normalized earnings will not be the answer in every situation. But unlike budgeting, cash forecasting and other more time-consuming tools, this technique may be able to provide a quick and realistic snapshot of your business’s earning potential.