Normalization

Normalization is the process of adjusting a business's historical financial statements to reflect the true, sustainable earnings that would be available to a new, unrelated owner. The result — normalized EBITDA or normalized SDE — is the earnings figure used as the basis for valuation.

Normalizing adjustments fall into two main categories: (1) owner-specific items that would not continue under new ownership (above-market owner salary, personal vehicle or travel expenses, family members on payroll with no business function), and (2) non-recurring or one-time items that distort the trend of earnings (a flood insurance claim, a one-time legal settlement, a lease renegotiation cost). Adjustments that increase earnings are called add-backs; adjustments that reduce earnings (such as replacing an underpaid owner with a market-rate manager) reduce the normalized figure.

Normalization is scrutinized by buyers during due diligence through a Quality of Earnings (QoE) review. The CRA also reviews normalizing adjustments on transactions where the seller claims the Lifetime Capital Gains Exemption.

See also: Add-Back, EBITDA, SDE, Quality of Earnings, Due Diligence.