What’s New at CFI: Normalizing Income Statements

Transcript

Meeyeon (00:16)
Welcome to another episode of What’s New at CFI. I have Jeff again here. How’s it going, Jeff? 

Jeff Schmidt (00:23)
Good, how are you?

Meeyeon (00:25)
Great. Now we’re going to talk about something that I’ve been really excited for this course, because this brings me back to my memories of university when I was an intern on the buy side initially, as well as when I was an investment banking analyst. It’s on the topic of normalizing income statements.

Because when I think of normalizing income statements, just kind of means that you have to deal with realities that like not everything is cookie cutter. You can’t compare things right away. It’s not going to be that easy.

Jeff Schmidt (00:55)
Completely different than when you’re taking courses at university, right? Everything’s pretty clean and pretty straightforward. But the real world’s a lot more complicated. Part of this course is…

so, you know, basically during any given accounting period, there’s going to be non-recurring or unusual gains or losses that impact a company’s financial statements. And part of this course is going in and identifying those non-recurring items or those unusual items and then removing them from the income statement, resulting in what we are calling a normalize

income statement. Basically the point is we want to understand the underlying profitability of that company excluding those non-recurring items that fluctuate and are really hard to predict. And even though we call the course normalizing income statements, a normalization can be called many things like adjusted income statements or adjusted metrics or non-GAAP or non-IFRS metrics. But the process is still the same.

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Meeyeon (02:10)
Yeah, because we have to, at the end of the day, account for all the one-off events that kind of happened in the course of life and the life of the company to make sure that we can compare, as the common saying goes, apples to apples.

Jeff Schmidt (02:16)
Mm-hmm.

Exactly.

Meeyeon (02:24)
And so in, like in real life, what would you say are some examples of nonrecurring items?

Jeff Schmidt (02:31)
Sure, there’s a ton, and obviously, we get into the most common in the course, but a couple of it stand out to me. The first one is restructuring expense. That’s usually a big one. Companies will periodically restructure their operations to become more efficient and hopefully profitable. So another one is is gain or loss on the sale of an asset or assets.

In this case, what we mean, though, is selling an asset that actually isn’t being used in the operations or the business. stuff like property, plant, and equipment, but not inventory. Inventory is used in the business to generate revenues. A gain or loss on the sale of an asset would be selling an asset that just kind of exists, but doesn’t directly impact

revenues or sales. So again we discuss these in quite a few others in this course. We also discuss a lot of other adjustments that many financial analysts like to make. So, for example, analysts often like to

exclude the amortization expense associated with acquired intangible assets. Okay, and there’s kind of a quirky accounting reason for that that we get into. And then another example is related to differences between how companies account for

things in the United States using US GAAP or how companies report internationally using international financial reporting standards. in the US, you’re allowed to use LIFO to account for your inventory. Outside of the US, LIFO is not allowed. So we discussed some of these other adjustments and if you want to compare a company that uses LIFO with a company that uses FIFO, how do you do that? So we get into a lot of detail with that.

Meeyeon (04:35)
The whole practice of normalizing income statements. From my experience, I just remember that it is something that I was like always like kind of dreading to do. It’s something that is absolutely necessary. But it’s like in the beginning, you’re just like very uncomfortable until you practice a skill you’re like, should I do this? Should I not? Like, am I making things worse? Am I like, is this allowed? What are some common pitfalls you think when it comes to normalizing income statements that people fall into?

Jeff Schmidt (05:02)
The biggest one, the most major issue, is that, in general, when we normalize income statements, we typically base those adjustments on what the company says to adjust. Okay, so basically, in other words, we’re taking the company’s word for it. If they say, remove this item, we typically do as analysts.

The issue, though, of course, is that companies and management teams…

They have incentive to make their numbers look better and these normalization adjustments almost always make the company look better. They’re almost always better than the official reported numbers. So it’s important to be aware of that bias that management teams have. They want to put again a better foot forward than the actual reported numbers. And so, when you rely on company-provided normalization adjustments,

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again, you’re sort of taking management’s word for it, but management is biased. So there’s an example that I often use. I don’t want to name names here, but there is a computer company based in the United States. We talked about, OK, what’s a common non-recurring item?

Well, restructuring expense, right? You restructure and then you’re not supposed to keep restructuring. In theory, you’ve streamlined, you’ve become more efficient. Well, this company has recognized restructuring expense in every year since at least 2002. So that’s $13 billion worth of restructuring costs over, you know, little over 20 years. So, you know, if you were just…

accepting that company’s numbers, remove these restructuring expenses, they’re non-recurring. They’ve been recurring for 20 years. So, as an analyst, you might not want to take the company’s word for it, and you might not want to remove restructuring expenses. Now I’m using a…

in order to get the point across, I’m using an extreme example of $13 billion of restructuring charges over 20 years. But again, you do want to be aware of the bias that management has and consider it when you’re making adjustments. But in general, you still tend to adjust based on the company numbers.

Meeyeon (07:44)
Sounds like this is going to be an essential piece of learning the language of business and accounting and so it’s not, it’s not an easy topic to tackle but I’m sure that this course is going to be filled with hands-on applied practice, so our learners can give it a go and get comfortable because this is something that you cannot avoid it’s going to be done in any type of financial analysis that we do.

Jeff Schmidt (08:08)
And we use, we do two different normalization exercises. One is a US GAAP company and the other is an IFRS company as well. 

Meeyeon (08:19)
Oh, thanks.

Jeff Schmidt (08:20)
So you get a mix of the differences.

Meeyeon (08:23)
Ok yeah. That was definitely going be my next question because I’m sure that our listeners are going to ask about that.

Jeff Schmidt (08:29)
Yeah, definitely.

Meeyeon (08:30)
So, dive right in if you want to get practice on normalizing income statements. It’s going to be something that comes up all the time in any type of analysis.

And for now, we will say goodbye and see you next time.