Financial Recasting, the 3D Ultrasound of a company

This process gives perspective into a company’s past performance and potential. This step is crucial in valuing a business, but it involves more than just reading the financial statements. It requires detailed analysis and an understanding of the company's current and future operations. With this knowledge, you can begin to see the true financial picture. Adjustments to normalize earnings typically fall into three categories: accounting, discretionary, and one-time.

Accounting Adjustments: Accounting adjustments address items influenced by a company’s accounting methods. Common adjustments include converting earnings from a tax basis or cash basis to an accrual basis to provide a more accurate picture of income and expenses. Inventory valuation methods, such as switching from LIFO to FIFO, can also affect earnings visibility. Additionally, depreciation and amortization methods must reflect the actual economic use and value reduction of assets.

Discretionary Earnings: Discretionary earnings involve items incurred or recorded at management’s discretion. This often includes salaries, wages, and bonuses paid to owners, family members, and friends, which may be unnecessary or unreasonable. Adjusting these to market rates creates more representative, normalized earnings. Related-party transactions are scrutinized to ensure they occur at fair market value. Perquisites and benefits, often disguised as business expenses, are also adjusted to reflect true costs.

One-time Expenses: One-time items are unusual, one-time income or expenses that are not expected to recur. Examples include lawsuit settlements or changes in commission policies. These items need to be adjusted to present a clearer picture of the company's ongoing earnings.

In addition to these adjustments, it's important to investigate unexplained discrepancies in the financial statements. For example, if a company reports a loss but the owner has just purchased a vacation home, further analysis and adjustments may be needed to determine the company’s true earnings.

Carlos F. Guevara CBI @cguevaracbi #EarningsNormalization #BusinessValuation #FinancialAnalysis #EconomicAdjustments #DiscretionaryAdjustments #NonrecurringItems #AccountingMethods #CorporateFinance #ValuationInsights #BusinessFinance