We recently published an article outlining the importance of having your company valued before going to market. In that piece we examined why this is important for YOU(so you have a good idea of the current market value) and for BUYERS (so that they know you are committed to actually selling your company and you have appropriate value expectations). We also mentioned how vital it was to use “recast” financials as part of the evaluation process. Given the fact that most business owners are not familiar with this term and concept, we wanted to do a follow-up piece on recasting, providing you further details on this key step in any valuation process.
So what is recasting (also called normalization)? There are actually several definitions:
From Investopedia:
The act of amending and re-releasing a previously released earnings statement, with specified intent. Some of the most typical reasons for recasting earnings are to show the impact of a discontinued business or to separate out earnings-related events that are deemed to be non-recurring or otherwise non-representative of normal business earnings.
From The Houston Chronicle:
Normalizing a financial statement involves adjusting it so that it reflects only the "normal" affairs of a company. For example, your business might own a single parcel of land. If you sold that land, the gain from the sale would go on your income statement and would increase your profit for the year. But the land sale would be a one-time event -- an aberration. You won't be selling more land in the years to come, so that gain isn't repeatable, and your profit for the year is abnormally high. On a normalized income statement, you would remove the land sale, along with all other one-time, unusual or nonrecurring items. The only items that would remain on the statement would be the revenues and expenses directly related to the normal operations of your business.
From the Generational Equity M&A Glossary:
Recasting, or financial statement adjusting, eliminates from the historical financial presentation items that are unrelated to the ongoing business, such as superfluous, excessive, or discretionary expenses, and nonrecurring revenues and expenses. Recasting provides an economic view of the company as though it were run by management dedicated to maximizing profitability and allows meaningful comparisons with other investment opportunities.
To sum up, recasting is a GAAP (Generally Accepted Accounting Principle) approved method by which you are allowed to restate your financials to reflect the true historic profitability of your business. The key point is found in the last sentence of the last definition above: It allows “meaningful comparisons” to other investment opportunities.
This is especially critical when you present your company to buyers. If you are providing historic numbers that are not adjusted, then a buyer will be looking at your company in comparison to others, many of which will be using recast financials, that will force them to discount your value (because your true earnings will be understated) when they do their comparative analysis. Now professional buyers will not let you know this since they will be looking for the best possible deal. However, this happens all too often to unsuspecting entrepreneurs who attempt to find buyers without professional M&A advice.
The reality is you and your accountant have worked very hard, and legally, throughout the years to keep your tax burden low by expensing items that may not be directly related to the ongoing operations of your business. You may not even be aware of the impact that recasting may have on your financials. Many are not until they go through our evaluation process. Some typical examples of recasting that we encounter include:
This is just a short list of some of the common recasting situations we see. There are literally dozens of others that also crop up.
The key for you is this: Recasting is a VITAL step that needs to be done long before you approach any buyers. If you don’t, you may be understating your true profitability. This could end up costing you thousands and thousands of dollars in lost value.
However, just as importantly, the accuracy of any recasting done to your financials is paramount. In your offering memorandum that will be provided to buyers who sign a CA (confidentiality agreement) with you will need to outline – clearly and in great detail – what is being recast and why. Buyers will be concerned if you are unable to provide specific details regarding what is being revised and why it is being adjusted. And, since you are most likely not an accountant and have never recast financials before, you need to ensure that any adjustments made are legitimate.
Given the need for accuracy, documentation, and legitimacy, it is far better to hire an M&A advisor to provide this service to you rather than try to do it on your own or have your in-house accountant do it for you. He or she may be able to do some basic recasting work, but to really dig deeply into your situation requires a professional with years of experience.
This is what sets Generational Equity apart from others providing this service: We are the leading M&A firm working in the middle market. In fact, our valuation team was recognized last year by The M&A Advisor as the “Valuation Firm of the Year,” and have received numerous industry awards.
These are peer review awards and mean a great deal to us because they are not easy to achieve and are reflective of the tremendous service we provide to our clients. If you would like to learn more about recasting specifically, M&A trends in general, or about our services, please make plans to attend a Generational Equity M&A seminar. These are provided with no obligation on your part and are conveniently held in cities throughout the U.S. and Canada.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
Updated June 2021
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