Identifying and Adjusting Other Income
Companies may report secondary sources of income that are not derived from its main business on their income statements. To determine whether this income should be included in the value of a business, you must first know what the income is related to.
Companies may report secondary sources of income that are not derived from its main business on their income statements. To determine whether this income should be included in the value of a business, you must first know what the income is related to. Often, this income is reported as:
· Sale and gain on an asset or investment
· Disposition of a business segment
· Gain from a legal case
· Insurance settlement
· Gain on early retirement of debt
· Any other one-time sale
These income sources could be classified as “other income,” “miscellaneous income,” or not otherwise be clearly identified on the business’s financial statements.
After these income sources have been identified, the person valuing the company will need to determine whether the income is related to the normal operations of the business and that a hypothetical buyer would also benefit from this source of income. If the income is in fact related to the core operations of the business and is likely to recur, then yes, it should be included in the value of the business.
If the income being reported is deemed not related to the core operations of the business and non-recurring, then it will have to be removed from the company’s cash flow accordingly in each year that it incurred. One example of non-recurring income is net gains from the sale of an asset. If such an income is reported in one of its historical years, then this amount should be removed from the company’s net income in that year as hypothetical buyer could not benefit from the sale of this asset in the future. Another example of other income that should not be included in the value of a business is rent income. If a company owns real estate which generates income, this rental income will be included on its financial statements. However, as this is not related to the core operations of this business, any rental income would need to be removed from the net income to realize the true cash flow of the business.
In the end, every business is unique, making every business valuation just as unique. When considering whether other income should be included in the value of a business, ask yourself the following questions:
· Is this form of income generated from the core operations of the business?
· Will a hypothetical buyer incur the benefits from this income?
· Will the income be recurring in each year?
If the answer to each question is ‘yes,’ then the income should be considered for inclusion to determine the value of the company. If the answer to the above questions is ‘no,’ then the income should likely be removed from the company’s net income in each year it is incurred.
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