3 statement models - normalising?
Hi all,
Trying to understand best practice for normalising when it comes to 3 statement models.
When it comes to comps etc. i think it’s fairly straight forward. However, when normalising the income statement there a few points that aren’t entirely clear to me:
1) Costs are embedded in line items eg COGS. Would we need to strip them out? However, wouldn’t that change the historical numbers we’re working with?
2) Financial statements aren’t always clear where the adjustments are coming from. Eg they’ll walk through how to get from operating profit to underlying profit. But they won’t tell you where these adjustments came from (eg they might be embedded in COGS). Hence, you might inadvertently be double counting.
3) If we strip stuff out etc and end up changing the EBIT number we’re using, won’t that change the tax and net income? What would the tax be? Similar question to 1 but it seems like we’re completely changing the historicals?then?
4) What’s the general best practice for presenting normalisation adjustments and subsequently projecting the operating model?
Thanks!
1) Not all costs are embedded in COGS line item. Only the cost of inventory or services is included there. The SG&A line might lump together other charges and expenses that don't fall under COGS. Oftentimes, depreciation is included under SG&A. Other expenses and losses (especially non-reoccurring ones) are listed separately, and sometimes, depending on the type of account, a disclosure is made in the notes.
2) Sometimes companies will reconcile the Adjusted EBITDA numbers. Since EBITDA is not GAAP, companies are not required to disclose it or reconcile it. The ones that do, will usually add disclosures and notes.
3) If you make one-time adjustments, you need to do similar adjustments to all historical values for non-recurring transactions. Ignore the effects on retained earnings (that is, don't carry adjustments from one period to another). On a tax note, this will change your financial pre-tax income, but 99% of the time your financial pre-tax income won't be the same as your taxable income anyways (DTAs and DTLs are use to reconcile these temporary differences)
4) I start by laying out the audited financial statements as presented shown on the 10k. Then make normalization adjustments (remove discretionary expenses, non-recurring gains or losses or and other non-recurring transactions). Show the adjustments at the bottom and add footnotes (reference 10k, 10q etc). Lastly, show the normalized financial statements.
You have to spend some time reading the notes. That and linking the statements properly are the key learning points of this exercise. If you can master both, this will become rather easy. Additionally, you have to ask yourself why you are normalizing the financials. Do you only need EBIT/EBITDA, or do you need fully normalized financials?
Extremely helpful - thank you!
To summarise then, we essentially create an entirely new set of historical accounts using our adjustments when creating a 3 statement model. We have an additional schedule in which we footnote these adjustments to show how they reconcile to the audited accounts.
It really depends on what your goal is. In theory, you could normalize all the financials for a given fiscal year (IS, BS, & CFS), but that would certainly be a lot of work. For the most part, you only normalize the key items (e.g. Revenue, EBIT, EBITDA, OFC etc.). COGS and SG&A almost always remain untouched. Unless something weird happens, a change in accounting principles (e.g, inventory valuation method changes from LIFO to Average Cost). In which case, the company must conduct those adjustments retrospectively and show adjusted comparative statements (in short - they’ll do the work for you). In banking you are more concerned about one-time gains and losses that occur during the operating cycle (e.g, M&A fee, Impairments, one-time legal fees) . You want to remove those infrequent gains and losses (or expenses), since they are not actually representative of the company’s actual cash flows. Cash is king, and your ultimate goal for valuation purposes is to see how much cash is coming in, and how much cash is leftover after financing the company’s operations. The method you choose to accomplish this is irrelevant - it’s difficult to explain or this idea since you can choose to get very technical (this requires a bit more of accounting knowledge and honestly, the results won’t change much), or you can simply estimate. Once you are working on an actual operating model, something you won’t realistically do as a first year, you start to worry about the impact of taxes and whatnot. For example, the “Income Before Income Taxes” line you see on 10Ks is known as the accounting profit. The issue is that GAAP requires companies to use the accrual method of accounting, while the IRS uses the modified-cash method. This means that “Income Before Income Taxes” line (accounting profit) will be different than the “Taxable Income” line (tax profit). The difference between the two creates temporary differences that reverse over time (DTLs and DTAs). The tax treatment is a bit more complex and counterintuitive, so I suggest that you do a quick google search and try to understand it.
Here’s something that I think about all the time: there’s this book called “Accidental Investment Banker”, at one point the author discusses his first experience when dealing with pitchbooks. Senior bankers include league tables to show the volume and size of their previous transactions. However, they tend to massage the hell out of the numbers to show them as the market leader in a specific vertical. Those pages are usually full of footnotes (e.g. “Only includes transactions from Jan 1st to Jan 6th”, or something silly along those lines). My point is that as long as you disclose where and how you got your information, you can tell whatever story you want. You’ll soon realize that this is a game of guessing and bankers get paid to play it.
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