Normalization Adjustments: Where on the Financial Statements to Look

Understanding Normalization Adjustments

At its core, valuing a Main Street business comes down to one question: how much does it actually earn?

That’s not always easy to answer. In smaller businesses, owners often run personal or discretionary expenses through the company, and tax strategies are commonly used to minimize reported income. As a result, the financial statements don’t always reflect how the business truly performs.

These adjustments are often called “add-backs” or “recasts,” but those terms can be misleading—not every adjustment increases earnings. We use the term normalization adjustments because the goal is simple: show what the business would earn under normal, ongoing operations. Determining what qualifies as an adjustment is not always straightforward, especially in SBA valuations where the analyst is often working from the financials alone.

Let’s start with how the industry defines normalization. There are several organizations that issue certifications for business valuation. These organizations opt to provide more principles-based guidance rather than a checklist.

Normalization adjustments are defined similarly across the major valuation organizations, though each approaches the concept from a slightly different angle. The National Association of Certified Valuators and Analysts describes them as adjustments made to financial statements to better reflect the true economic results of the business. The American Institute of Certified Public Accountants focuses on eliminating unusual, nonrecurring, or non-operating items to arrive at ongoing earning capacity. The American Society of Appraisers refers to the process as recasting financials to reflect how the business would perform under typical ownership and normal operating conditions.

In plain terms, all three are getting at the same idea: presenting a realistic, sustainable level of earnings. What they do not provide is a strict checklist of what qualifies as an adjustment. Like much of business valuation, this process is judgment-based and evaluated case by case. Because of this, the support and rationale behind each adjustment becomes critical. The sections that follow outline the primary categories of normalization adjustments for both the balance sheet and income statement, along with common items seen in SBA valuations that warrant closer review.

The applicable standard of value also impacts how financial statements are normalized. The SBA recommends applying the fair market value standard when valuing a business. Considering buyer-specific synergies that a purchaser might realize from acquiring a particular company is discouraged. All normalization adjustments should be based on a hypothetical willing buyer, consistent with fair market value. Accordingly, we assume the Company will continue to operate as it historically has. Projections, buyer-specific synergies, and transaction-related assumptions are disregarded.

Criteria for Making Adjustments

Normalization adjustments are inherently judgment-based and are made when our analysis indicates that:

• Reported amounts are inconsistent with fair market value for a given line item
• A reasonable basis exists for determining the adjustment
• The authority to make such adjustments lies with the controlling interest, or appropriate disclosures are made

Types of Normalization Adjustments

Normalization adjustments generally fall into four main categories:

• Comparability Adjustments – Aligning reporting with industry norms
• Non-Recurring Adjustments – Removing one-time or unusual items
• Non-Operating Adjustments – Excluding items unrelated to core operations
• Discretionary Adjustments – Reflecting owner-controlled decisions at market levels

While, in theory, almost every line item on a financial statement could be adjusted, in practice most SBA valuations focus on a relatively small group of common items.

A general rule of thumb is:

If removing an expense would change how the business actually operates, it’s probably not an add-back.

This simple test helps distinguish between legitimate normalization adjustments and overly aggressive attempts to inflate earnings.

Each of these categories—and the common adjustments within them—can become more nuanced depending on the facts of the engagement, and will be explored in more detail in future articles.
 
In most SBA valuations structured as asset sales, the buyer is acquiring a defined set of assets—typically fixed assets and inventory (if applicable)—while the seller retains cash, receivables, and liabilities. As a result, the post-sale balance sheet will often bear little resemblance to the historical financial statements.

This distinction is important. Valuing an asset sale requires focusing on what actually transfers to the buyer, rather than analyzing the business as a complete going concern.

Accordingly, balance sheet adjustments in these engagements are generally limited and focused on comparability, rather than reconstructing a fully normalized balance sheet.

In contrast, stock sales and partner buyouts involve the transfer of the entire entity, making balance sheet accuracy much more critical. In those cases, adjustments are more extensive and often necessary.

Common examples include:

Cash – Excess cash can distort working capital and cash flow metrics and is typically treated as non-operating
Accounts Receivable – Significantly aged receivables (generally over 120 days) may not be collectible
Shareholder / Related Party Receivables – May require reclassification or removal to avoid distorting working capital
Real Estate – Typically removed to isolate the value of the operating business and valued separately
 
Officer Compensation – Major factor in determining SDE. Often influenced by tax strategy or personal considerations rather than market reality. Compensation should be normalized to reflect the market cost of a qualified operator.
Other Salaries & Wages – Adjustments may be required for non-essential personnel, employees not continuing post-sale, or compensation that deviates from market levels
Rent Expense – Related-party or inconsistent rent should be adjusted to fair market lease rates
Other Operating Expenses – May include discretionary items such as:

• Consulting fees
• Management fees
• Cell phone expense
• Auto expense

While reviewed, these items are typically not primary drivers of value and should be evaluated in context.

Normalization adjustments are not about making the numbers look better—they are about making the numbers realistic. Each adjustment should be supported by documentation, third-party data, or a clear and defensible rationale. When done properly, they provide a clear picture of what a business can actually support under typical ownership.

In the SBA context, this matters. Overstated earnings, whether from aggressive add-backs or unsupported assumptions, can lead to deals that appear viable on paper but struggle in practice. A well-supported valuation doesn’t stretch to justify a purchase price. It reflects what the business can truly deliver.

Lance LeBlanc, C.V.A., is the President of Green Country Business Valuations, a firm specializing in SBA business valuations for lenders across the country. He has completed thousands of valuations and works closely with processors, underwriters, and lenders to support them through the underwriting process.