Pre-Sale Processes: 4 Tips for Standardising Financial Statements

The primary objective of business owners is often to minimise taxes and maximise profits for themselves and their families. This often involves tactics such as maximising advantages and benefits, employ family members, and deduct various expenses through the business. While normalising financial statements can help to reduce taxes and increase personal profits, they can also affect the real value of the company, especially when it comes to its valoration

Financial statements play a key role in the valuation of companies, as they serve as the basis on which the valuation is built. However, these financial statements often have to undergo a process known as normalisation or restatement to reflect the the company's real earning capacity. Normalising the financial statements involves making a series of adjustments to the financial statements to eliminate owner-specific benefits, benefits and expenses, thus showing the actual cash flow available to the company.

Reminder: Distinction between EBITDA and Cash Flow

It is important to take into consideration that the EBITDA (earnings before interest, tax, depreciation and amortisation) and the CASH FLOW are not the same. While EBITDA serves as a useful measure to assess operating performance, cash flow reflects actual income and expenses, including changes in working capital and investments. When making financial adjustments, keep this distinction in mind to provide an accurate picture of your company's financial situation.

Types of adjustments when normalising the financial statements

When normalising financial statements, a number of adjustments are made to ensure an accurate representation of the company's earning capacity. These adjustments play a crucial role in eliminating distortions caused by non-recurring events or owner-specific expenses. The main types of adjustments that are commonly made are listed below:

1. Discretionary expenditure: Discretionary expenses include costs incurred by the company that primarily serve the company's business purpose. The personal benefit of the owner rather than contributing directly to the company's operations or to the welfare of employees. Examples are extravagant entertainment expenses, luxury travel or high-level personal benefits provided by the company. By identifying and excluding these expenses, the financial statements reflect a more realistic picture of the company's operating costs and profitability.

2. Extraordinary expenses: Extraordinary expenses refer to one-off or infrequent costs that are exceptional in nature and unlikely to recur in the normal course of the company's operations. These expenses may arise from unforeseen events, such as natural catastrophes, litigation or major write-downs. By segregating and adjusting for these expenses, standardised financial statements provide a clearer picture of the company's current operating results, free from the distortions caused by extraordinary events.

3. Non-operating income and expenses: Non-operating income and expenses comprise financial transactions that are not related to core business activities and are not related to the core business. do not directly contribute to income generation or to support operational objectives. Examples include interest income from investments, gains or losses from asset sales, or proceeds from insurance settlements. By excluding these non-operating items, the adjusted financial statements focus only on the company's core operating performance, which facilitates a more accurate assessment of its profitability and financial health.

4. Non-recurring income and expenses: Non-recurring income and expenses are items that occur on an irregular or infrequent basis and are not expected to affect the financial results of the business on an ongoing basis. They may include one-off expenses such as major capital investments, restructuring costs or windfall gains from asset sales. By adjusting for these non-recurring items, the financial statements provide a standardised view of the business' profit potential and underlying operating efficiency, enabling stakeholders to make informed decisions based on sustainable financial metrics.

Tips for making adjustments

Making accurate and appropriate adjustments to financial statements is crucial to ensure transparency and credibility during the business valuation process. Here are some tips on how to make effective adjustments:

1. Thorough documentation: Providing comprehensive documentation for each adjustment is essential to justify its validity and accuracy. The detailed records, such as invoices, receipts, contracts and supporting data, reinforce the credibility of adjustments and instil confidence in potential buyers.

2. Adopt conservatism: Adopting a conservative approach when making adjustments is crucial to avoid overstating the company's earning power. By erring on the side of caution, the risk of buyer scepticism is mitigated and an environment of confidence in the financial information presented is fostered.

3. Minimise settings: Make an effort to minimise the number of adjustments, by focusing primarily on significant expenses that have a material impact on the company's cash flow. By prioritising essential adjustments and avoiding trivial or insignificant items, you streamline the valuation process and increase clarity for potential buyers.

4. Maintain transparency: Transparency is essential to generate trust among potencial buyers Clearly communicate the reasons for each adjustment and provide buyers with ample opportunity to independently review and verify adjustments. Openness and honesty in financial reporting helps establish trust and credibility, facilitating smoother negotiations and transactions.

How to easily generate a detailed list of settings

To efficiently generate a detailed list of settings, follow these steps:

1. Export the profit and loss account: Export a detailed profit and loss statement from your accounting software to a spreadsheet program such as Excel. This report should include each transaction individually for accuracy.

2. Identify and mark the settings: Carefully review each transaction in the profit and loss account to identify items requiring adjustments. Mark each adjustment directly in the spreadsheet, either by adding an additional column or by highlighting the corresponding rows.

3. Provide supporting documentation: Ensure that you have supporting documentation for each adjustment, such as invoices, receipts or contracts, to validate the need for each adjustment.

4. Review and finalise: Conduct a thorough review of the adjustments for accuracy and completeness before submitting the list to potential buyers or interested parties. Once satisfied with the accuracy of the list, finalise it for distribution.

Standardising financial statements to maximise enterprise value

As we have seen, standardising the financial statements is a fundamental step in the valuation a company's needs. By diligently carrying out the essential adjustments to reflect the true revenue potential of the company, salespeople significantly improve transparency, credibility and ultimately optimise the value of your company during a sale.

Adhere to best practices throughout this process, such as being thorough in identifying adjustments, conservative in estimating values and meticulously document all transactions, ensures that potential buyers receive accurate and reliable financial information. In addition, maintaining transparency and integrity in financial information not only instils confidence in potential buyers, but also encourages smoother negotiations and transactions.

Ultimately, standardising the financial statements correctly not only reflects the true financial health of the company, but also contributes to the achievement of the the best possible result for both the seller and the buyer in the sales process.