How can you adjust financial statements for non-recurring items?

1 What are non-recurring items?

Non-recurring items, also known as extraordinary, unusual, or one-time items, are typically reported separately from the operating income or loss in the income statement and may have a significant impact on the net income or loss. Examples of non-recurring items include impairment charges or write-offs of goodwill, intangible assets, or fixed assets; restructuring costs or severance payments; gains or losses from discontinued operations or asset sales; legal settlements or fines; natural disasters or pandemic-related expenses; and changes in accounting policies or tax laws.

2 Why adjust for non-recurring items?

Adjusting for non-recurring items is a common practice in financial analysis, especially in valuation methods that use earnings multiples, such as price-to-earnings (P/E) or enterprise value-to-EBITDA (EV/EBITDA). The reason is that non-recurring items can inflate or deflate the earnings of a company in a given period, and make them inconsistent with the earnings of other companies or the industry average. By adjusting for non-recurring items, you can obtain a more accurate and comparable measure of the normalized or sustainable earnings of a company, and thus a more reliable valuation.

3 How to identify non-recurring items?

Identifying non-recurring items can be tricky, as different companies may have different definitions and disclosures of what constitutes a non-recurring item. Additionally, some items may be recurring in nature, yet vary in magnitude or frequency, such as depreciation, amortization, or stock-based compensation. Thus, it is essential to carefully examine the financial statements and notes of a company, and use your judgment and common sense to determine which items are truly non-recurring and which are not. When analyzing the financials, look for clues such as the description and nature of the item, the amount and frequency of the item, the impact and relevance of the item to the core business operations, and the treatment and classification of the item by the company and industry.

4 How to adjust for non-recurring items?

Adjusting for non-recurring items is a simple process of adding or subtracting them from the reported earnings of a company, depending on whether they are positive or negative. For example, if a company reports a net income of $100 million, but also reports a $20 million impairment charge and a $10 million gain from an asset sale, both of which are non-recurring items, you can adjust the net income by subtracting the impairment charge and adding the gain from the asset sale, resulting in an adjusted net income of $90 million. You can then use this adjusted net income to calculate the earnings multiples or other valuation metrics.

5 What are the limitations of adjusting for non-recurring items?

Adjusting for non-recurring items can improve the quality and comparability of financial statements, but it also has some limitations and drawbacks. For instance, it can be subjective and inconsistent, as different analysts may have different opinions and criteria on what constitutes a non-recurring item. Moreover, it can be misleading or manipulative, as some companies may use non-recurring items to mask or inflate their earnings or to justify their valuation. Additionally, it can ignore the future implications or risks of non-recurring items, such as the impact on cash flows, taxes, or competitive position. Lastly, it can create unrealistic expectations or benchmarks, as some non-recurring items may reflect the reality or trends of the business environment or industry.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?