Normalized Earnings
The entity’s profitability, eliminating any seasonal one-off events.
What are Normalized Earnings?
Normalized earnings are important in finance. If you are unaware, earnings is a crucial number that gets reported quarterly, or whenever a company’s fiscal period ends. Earnings is another way to say profits. In other words, it is the company’s profit for that period.
Reported earnings are the official figures presented in a company’s financial statements.
Normalized earnings adjust these numbers by removing one-time events. This provides a better perspective on a company’s profit or loss.
The term’s definition is the entity’s profitability, eliminating any seasonal one-off events. This includes any fluctuations and unusual events.
Normalized earnings provide a truer reflection of a company's performance since any unusual events or factors are taken care of. Read the NASDAQ’s definition of normalized earnings here.
Often, companies deal with irregular events. These financial circumstances distort the real profitability of a company.
Normalized earnings may be considered seasonal events, but their primary focus is on removing one-time or irregular events that don't reflect the company's ongoing performance.
These earnings take seasonal trends and discrepancies into account. Therefore, the metric is of importance to stakeholders and investors.
This metric is preferred since it clearly shows the company’s profits. There are a few reasons why this metric is important. There is a certain method to normalize an entity’s earnings. Finally, we will go over why normalization is beneficial.
Let’s discuss the importance, calculation, and benefits of normalized earnings.
Key Takeaways
- Normalized earnings are an entity’s profitability without any seasonal events factored in.
- The basis of normalization is to make the earnings “normal,” that is, without any unusual items or transactions.
- Normalization is important, particularly to stakeholders and investors.
- Big companies already use this practice, but as more and more people invest in small companies and startups, perhaps every company should look to use this practice.
- Normalized earnings offer clearer insight, a reduction in misleading signals, and increased comparability.
Significance of Normalizing Earnings
Earnings can be all over the place due to accounting practices, fluctuations in the entity’s demand, and one-time events.
Some figures do not accurately show a company’s financial status. Each financial metric includes different variables. Some use prior numbers, while some only use the current period’s data.
To mitigate the effect of one-time events on a business’s finances, the firm may normalize its figures.
Normalizing earnings….
1. Reduce volatility
Normalized earnings reduce volatility. Stakeholders and the company care more about the enduring trends.
No one bothers if a company faces a singular high expense. Sure, it is important at the moment, but it provides no importance to stakeholders. Stakeholders worry more about general profitability and trends. Long-term, normalized earnings are a key figure.
2. Compare performance
Normalized earnings are of particular importance in sectors where plenty of external factors are present. These sectors are tourism and retail. Entities in these sectors should normalize so that variations are dealt with and performance can easily be compared.
3. Rectify figures
People may ask why to normalize. Normalization is done to rectify items that are one-time or non-recurring. Examples of such items are legal settlements and write-offs. Some events are not repeated; they are one-time. Such events can throw off earnings figures.
That is why it is important to normalize so that these misleading figures are rectified. Distorted earnings can make a profitable company look like it is making a loss.
4. Provide accurate figures to stakeholders
Regarding distorting the truth, investors make decisions based on these earnings figures. Therefore, they may decide to invest in a company, but if the distorted earnings make it look like the company is running a loss, the investor may decide not to invest.
A similar reaction may occur if the is running a loss, but the distorted earnings cause investors to invest in the entity.
Misleading earnings figures can be solved by normalization, which then provides the most accurate information to investors and stakeholders.
All around, normalization benefits various parties.
Steps to Normalize Earnings
Normalization is not very involved; it consists of some basic subtraction. The business must ensure it deducts or adds whatever non-recurring transactions occur. This is to provide a more accurate earnings figure.
The earnings figure, also known as net income, is found on the income statement. Take that figure and then deduct or add any one-time items depending on the item. Such items include
- Write-offs
- Legal settlements
- Acquisitions
- Restructuring
If these amounts were included in the earnings, it would tarnish the business’s operations and performance. Stakeholders would feel that the company performed differently.
Make sure you consider these unusual events and deduct or add them from the earnings, or net income, figure. Each item has different conditions regarding addition or subtraction, so make sure to double-check the items before finalizing earnings.
By eliminating these unusual gains or losses, businesses can provide a more useful earnings amount. Stakeholders prioritize earnings, so these amounts need to be accurate.
The steps to normalize earnings are:
- Take net income
- Deduct/ add one-time events
Benefits of Normalization
Normalization offers numerous benefits. Let’s take a look at some of the benefits below:
1. Clear insight
Earnings provide a better understanding of a business’s core operations. If earnings are high, that means the business is doing a great job, and stakeholders are in a suitable position.
When non-recurring items are excluded from the earnings, these stakeholders get a better insight.
Through the normalized earnings, analysts and investors can use them in metrics like the P/E ratio. P/E is a commonly used metric in finance. It is the entity’s share price divided by its earnings per share.
This shows how much a person is willing to pay for each share of stock.
2. Reducing misleading cues
People would question whether the company is profitable if earnings were not normalized. Since it would not be clear what factors were utilized, it caused a lot of misinterpretation.
Irregular events increase confusion about an entity’s financial position. Through the practice of normalization, these signals are clear.
3. Comparability
Earnings that are adjusted for any one-off events provide an accurate figure. This is important for long-term analysis, particularly when comparing a business’s performance to its past performances and to other companies.
Stakeholders and investors can understand if the entity is worth investing in.
Normalized earnings offer 3 main benefits. These are clearer insight, a reduction in misleading signals, and increased comparability.
Examples of Normalized Earnings
Company ABC has a gross income of $100,000. They have depreciation, interest, and borrowing expenses of $15,000. They also have federal and state taxes totaling $2,500. The company makes a $3,700 loss on the sale of its assets. What are Company ABC’s normalized earnings?
Net Income = Gross Income - Depreciation, Interest, and Borrowing Expenses - Taxes
Net income = $100,000 - $15,000 - $2,500
Net income = $82,500
Normalized Earnings = Net Income + Loss on sale of assets
Normalized earnings = $82,500 + $3,700
Normalized earnings = $86,200
Here is another example:
Company Z has a net income of $560,000. The company makes a $71,700 gain on the sale of its assets. What are Company ABC’s normalized earnings?
Normalized Earnings = Net Income - Gain on sale of assets
Normalized earnings = $560,000 - $71,700
Normalized earnings = $488,300
Conclusion
Generally, normalized earnings are preferable to reported earnings. Reported earnings are practical for ensuring accounting standards, communicating with stakeholders, and comparing entities. The drawbacks are that it includes one-time events and is short-term.
On the other hand, normalized earnings eliminate one-off events, assess seasonal trends, forecast entities’ performances, and play a role in investment decisions. The cons of normalized figures are that there is a lack of transparency and adjustments made.
More companies should ensure they use normalized figures. The benefits outweigh the cons.
To sum up, normalization entails taking a company’s net income, also known as earnings, and then factoring out one-off events. These seasonal events are not recurring and should be included in the earnings figure.
Including these seasonal events would throw off the figure, and stakeholders would react to the information differently than they should have.
Normalized earnings play a significant role in financial analysis. They present information in a clear manner that reduces misleading information.
The practice has benefits. These are clearer insight, reduced misleading signals, and increased comparability.
In a financial setting where decision-making is key, normalized earnings bridge the gap between companies and individuals.
Before, individuals had to second-guess if the company’s earnings withheld any information or if significant seasonal events would affect the figure.
Now, this problem is resolved with this practice.
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