Learn about the important process of normalizing net income, which allows a clearer understanding of a company's ongoing net income by eliminating the impact of non-recurring items. From restructuring costs to unusual gains or losses, grasp how these elements can distort the true picture of a business's performance.
Key Insights
- Normalizing net income involves removing the influence of non-recurring items, providing a clearer view of a company's regular income.
- Non-recurring items, which are not expected to occur regularly, could include restructuring costs, unusual gains or losses, accounting policy changes, fines and penalties, M&A costs, and impairments and write downs.
- Identifying non-recurring items is a matter of judgement and can significantly affect the interpretation of a business's financial health.
- The process of normalizing net income is crucial for financial modeling and business valuation.
- Using tools like Excel, one can highlight and omit non-recurring items for a simplified income statement that better represents consistent business operations.
- Normalized net income is calculated by considering factors like income taxes and the earnings before these taxes, providing a more accurate understanding of a company's income.
Normalization Adjustments
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One-Time Items
Strip out non-recurring gains/losses (lawsuits, asset sales).
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Owner Compensation
Adjust to market salary if owner is overpaid/underpaid.
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Discretionary Spending
Personal expenses run through the business.
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Why Normalize
Shows true ongoing profitability for valuation purposes.
Normalizing net income refers to cleaning out the impact of non-recurring items to better understand a company’s ongoing net income.
Normalized net income helps in seeing the underlying trends in a business more clearly and plays an important role in valuation.
Non recurring item is a gain or loss found on a company's income statement that is not expected to occur regularly.
The identification of non-recurring items is subject to judgement, but the following are commonly considered:
- Restructuring/reorganization costs
- Unusual gains or losses
- Accounting policy changes which mean the items will not exist in future
- Fines and penalties
- M&A costs
- Impairments and write downs
Let’s take a look at the Income Statement of Starbucks. We did transfer all that information into the Excel spreadsheet to work on it.
Here it is. Let’s identify non recurring items here and exclude them from the calculation of Normalized Net Income. I will put all non recurring items in bold.
Also, we will combine line items to simplify our Income Statement for modeling.
I will use the data validation tool for that.
Highlight H5 – H22 (“IS” tab) and open Data Validation window (ALT A V). Choose “List” as a validation criteria and as a source a list of items from the “Normalized NI” tab with the simplified Income Statement for modeling. Then let’s allocate the line items into relative categories.
Now let’s use SUMIF function to sum up relative categories from the “IS” tab to the “Normalized NI” tab.
Let’s fill that formula to the right and down with CTRL + R and CTRL + D.
Let’s take care of totals now.
EBIT = Revenues – (Cost of sales + Operating Expenses + D&A).
EBT = EBIT + line items in the rows 9-11.
Next, I want to calculate income taxes for normalized EBT.
Let’s come back to the “IS” tab for that. And calculate the tax rate as Income Tax Expense / Earnings before Income Taxes. I will also find an average tax rate for the given historical years. It will give me 20.6%. I will take it as a tax rate to calculate Normalized Net Income.
Now let’s calculate Income Taxes for historical years as EBT * Tax Rate. And then calculate Normalized Net Income as EBT minus Income Taxes.
So, we just simplified Income Statement for financial modeling purposes and calculated Normalized Net Income.
