Why Normalizing Adjustments Matter in Business Valuation

When valuing a small business, financial statements rarely tell the whole story. Normalizing adjustments are used to correct or adjust the financials so that they reflect the company’s true economic performance—giving potential buyers, investors, and advisors a clearer picture of what the business is really worth.

These adjustments help strip out one-time, non-recurring, or discretionary expenses that don’t represent the ongoing operations of the business. Without them, your valuation might be inaccurate—and that could cost you in negotiations, financing, or strategic planning.

Step-by-Step: How to Apply Normalizing Adjustments

1. Start with Accurate, Year-End Financials

• Use the company’s income statement and balance sheet, ideally for the last 3–5 years.

• Reconcile with tax returns and bank statements to ensure accuracy.

2. Identify Owner-Specific or Discretionary Expenses

These are common in small businesses and might include:

• Owner’s salary above or below market rate

• Personal expenses run through the business (e.g., car, travel, cell phone)

• Family members on payroll who aren’t actively involved

• Charitable donations or personal memberships

  
  

Example: A business owner pays themselves $250,000 annually, but a market salary for the role is $150,000. The excess $100,000 would be normalized.

3. Remove One-Time or Non-Recurring Items

Adjust for income or expenses that are not expected to continue:

• PPP loan forgiveness

• Lawsuit settlements

• Gain or loss from the sale of assets

• Temporary rent concessions or relief payments

  
  

Example: A one-time $75,000 gain from selling outdated equipment should be removed—it won’t recur in the future.

4. Adjust for Accounting Method Differences

• Convert cash basis to accrual basis where necessary

• Remove or adjust for significant timing differences in revenue recognition or expense reporting

  
  

5. Benchmark Key Expenses

Compare major costs (such as rent, insurance, or cost of goods sold) against industry norms to identify outliers. If the company is over- or under-spending in key areas, adjustments may be appropriate.

6. Document and Justify Each Adjustment

Each adjustment should be clearly explained and supported with:

• Market data or industry benchmarks

• Contracts or agreements

• Internal records

  
  

Real-World Applications

• Valuation for sale: Sellers want to present a normalized picture to justify asking price.

• Litigation support: In divorce or partner disputes, normalized earnings reflect fair economic benefit.

• Financing or SBA loans: Lenders often require normalized financials to assess true risk and performance.

  
  

Common Mistakes to Avoid

• Over-adjusting: Removing legitimate business expenses to artificially inflate earnings.

• Lack of documentation: Unexplained or unsupported adjustments will reduce credibility.

• Ignoring market compensation: Failing to adjust for above- or below-market owner wages.

  
  

Best Practices Summary

✅ Start with accurate books and clean financials

✅ Be conservative and consistent with adjustments

✅ Focus on recurring, operational performance

✅ Use third-party benchmarks when possible

✅ Clearly document and explain each adjustment

For a deeper look into how valuation professionals apply these adjustments and how they affect your business’s value, check out our Business Valuation page.