Normalized earnings are adjusted to remove the effects of seasonality, revenue, and expenses that are unusual or one-time influences. They help business owners, financial analysts, and other stakeholders understand a company’s true earnings from its normal operations. For example, consider a retail firm that sells a piece of land resulting in a large capital gain; this revenue from selling land would be removed for normalization since the core business is selling products, not land.
Truly Comprehending Normalized Earnings
Normalized earnings represent a company’s earnings that exclude the effects of nonrecurring charges or gains. By omitting these one-off effects, normalized earnings present a clearer picture of a company’s core business performance. Additionally, they account for seasonal or cyclical sales cycles, enhancing the accuracy of the financial portrayal.
In essence, normalized earnings provide the most accurate assessment of a company’s actual financial health and performance. Companies often encounter situational expenses, such as large legal fees, or situational gains, like selling outdated equipment. Although these events impact short-term cash flow, they do not reflect a company’s long-term performance. Accurate analysis demands the removal of these effects.
Key Takeaways
- Normalized earnings eliminate the impact of one-off events and smooth out seasonal revenue variations.
- They better represent the genuine health of a company’s core operations.
- Normalized earnings per share enable comparing businesses by focusing on their core operations rather than extraordinary events.
Exemplifying Normalized Earnings
The necessity for earnings normalization arises when unusual expenses or revenues need to be excluded, or sales cycles need to be evened out.
When normalizing large, one-off costs or earnings, there are two types of adjustments usually involved. Consider a company selling depreciated truck assets and purchasing new ones; both the earnings from selling and the purchasing costs would be removed from the income statement by an accountant to normalize earnings.
Similarly, during an acquisition or purchase, the firm’s financial statements are normalized by removing salaries and other expenses related to the previous company’s owners and officers.
Another common scenario is seasonal sales influence. Here, normalized earnings are adjusted by calculating moving averages over set periods. For example, if a company earns $100 in January, $150 in February, and $200 in March, applying a two-month moving average will result in normalized earnings of $125 for February and $175 for March.
Benefits of Normalized Earnings for Investors
For investors, normalized earnings offer a significant advantage as they enable more precise comparisons between companies. Key metrics like earnings per share (EPS) can be significantly influenced by one-time events—positive or negative—that don’t reflect the core business. Thus, by focusing on normalized earnings per share, investors can evaluate and compare companies more accurately based on the true strength of their ongoing operations rather than transient anomalies.
Related Terms: capital gain, seasonality, moving average, earnings per share, EPS.
