Cleaning the NumbersHistoric accounts are produced for a wide variety of interested parties, from employees of the company through to investors and industry regulators. Accounts therefore include a lot of “noise”, items that are not strictly relevant for valuation or analysis. Accounts are also required by law to include all the transactions that have taken place during the period, whether they relate to the underlying activities of the company or not. It is therefore necessary to decide which items included in the accounts relate to the underlying performance of the company (operational items), which items are being used to finance the company (financing items) and which items do not relate to the company’s underlying activities (non-core items). This exercise must be performed to get to any starting point for comparison or valuation.
What is required is an exercise to “clean up” the accounts, using knowledge of the company to identify the underlying profitability and cash flow of the business. A relative valuation, such as a comparative company (“comps”) analysis where comparisons across a sector are made, will allow us to produce an analysis of the group of companies where the accounting data is truly comparable. In an absolute valuation exercise, the clean ongoing profitability and cash flow calculated can be used as the starting point or “base camp” for a forecast that will allow the extrapolation of historic trends to produce an income and cash flow statement if there are no detailed forecasts.
Income Statement Adjustments
Adjustments to Operating Income
Adjustments to Financing Items
Cash Flow Statement Adjustments
Balance Sheet Adjustments
Key learning points:
- Historic accounts include various items that do not relate to the underlying performance of a company. Historic accounts must therefore be “cleaned” up before they are used to compare companies or forecast forward returns.
- The main adjustments made to the income statement ensure only continuing items are included, that one-off items are excluded and that accounting anomalies such as pension costs are adjusted for.
- The main adjustments to the balance sheet relate to non-core assets being removed.