Field Guide to Business Valuation: Financial Statement Analysis

A Field Guide to Business Valuation delivers essential context for anyone looking to learn a little more about business valuation. It includes insightful tips that will help make valuations much less daunting. A common hurdle that any person involved in valuation will have to clear is financial statement analysis, and a lot goes into understanding that. Read on to learn more about making adjustments to financial statements.

According to IRS guidance from Revenue Ruling 59-60, business valuations are, “in essence, a prophesy as to the future.” The outlook of a business affects its value. People pay more for businesses with rosy futures than for those with dismal prospects.

As an indicator of future performance, analysts frequently look at historical financial statements and make adjustments to make historical results more representative of future performance. For example, the analyst may remove unusual expenses related to mitigating a security breach from a cyberattack because these expenses are unlikely to occur again in the future. Additionally, analysts may make adjustments to: (1) remove nonoperating assets and liabilities that are valued separately; (2) adjust for accounting methods that are different from industry peers; or (3) reflect the underlying economic reality of the company better. Another category of adjustments relates to control. Control-related adjustments are adjustments to optimize cash flow that only a controlling shareholder could make. These adjustments include reductions to owner’s compensation, elimination of related-party transactions, changes to rent, deployment of capital, and other items. The goal of these adjustments is to aggregate all monetary benefits of ownership into a single figure—business income—to use as a base in the business valuation.

One of the most common adjustments to earnings a valuation analyst will perform is to normalize compensation based on what a hypothetical willing buyer might do. Business owners may seek to minimize taxes at the corporate level by inflating salaries. This practice may meet its objective of reducing taxable income, but, by doing so, it also could decrease business value unless compensation is normalized. If a company paid for a vacation home for the owner/CEO, that cost is normally added back to earnings if this perk is not industry-standard.

This discussion of financial statement adjustments is just the beginning when it comes to understanding how to analyze financial statements. Learn more about this and other pertinent topics by getting your copy of A Field Guide to Business Valuation.