Normalised earnings: Explained

BY TIO Staff

|August 12, 2024

In the world of trading, there are numerous terms and concepts that traders must familiarize themselves with to be successful. One such term is "normalised earnings". This concept is integral to understanding a company's financial health and making informed trading decisions. Normalised earnings refer to the adjustment of a company's income statement to show what earnings would have been if certain irregular or non-recurring items were excluded. These adjustments provide a clearer picture of a company's true earning power.

Normalised earnings are particularly useful for traders and investors who are trying to compare the financial performance of different companies. They allow for a more apples-to-apples comparison by eliminating the impact of one-off events or accounting changes that can distort a company's reported earnings. In this article, we will delve into the concept of normalised earnings, why they are important, and how they are calculated.

Understanding Normalised Earnings

Normalised earnings are a measure of a company's profitability that excludes unusual or non-recurring items. These items can include anything from restructuring costs, to gains or losses from asset sales, to changes in tax law. By removing these items from a company's income statement, normalised earnings provide a more accurate picture of a company's ongoing operations.

Normalising earnings is not just about removing unusual items. It also involves adjusting for cyclical fluctuations in a company's business. For example, a retailer might have higher sales in the fourth quarter due to the holiday shopping season. By normalising earnings, traders can get a better sense of a company's underlying profitability, regardless of the time of year.

Why Normalise Earnings?

Normalised earnings are important for several reasons. First, they provide a more accurate picture of a company's ongoing operations. This can be particularly useful for traders who are trying to assess a company's future earnings potential. By focusing on normalised earnings, traders can avoid being misled by one-off items that may not be indicative of a company's long-term profitability.

Second, normalised earnings allow for better comparisons between companies. This is because they remove the impact of one-off items that can distort a company's reported earnings. By focusing on normalised earnings, traders can make more accurate comparisons between companies, regardless of their size or industry.

How to Calculate Normalised Earnings

Calculating normalised earnings involves adjusting a company's reported earnings for unusual or non-recurring items. The first step is to identify these items. This can be done by reviewing a company's income statement and notes to the financial statements. Once these items have been identified, they can be removed from the company's reported earnings to arrive at normalised earnings.

It's important to note that there is no standard method for calculating normalised earnings. Different traders may use different methods, depending on their trading strategy and the specific circumstances of the company they are analysing. However, the general principle is the same: to adjust reported earnings to provide a more accurate picture of a company's ongoing operations.

Examples of Normalised Earnings Adjustments

There are many different types of adjustments that can be made to a company's reported earnings to arrive at normalised earnings. These can include, but are not limited to, the following:

Restructuring costs: These are costs associated with a company's efforts to reorganise its business. They can include things like severance pay for laid-off employees, costs to close or consolidate facilities, and costs to write off obsolete inventory.
Gains or losses from asset sales: These are gains or losses that a company recognises when it sells assets. They can distort a company's reported earnings because they are not part of a company's ongoing operations.
Changes in tax law: Changes in tax law can have a significant impact on a company's reported earnings. By adjusting for these changes, traders can get a more accurate picture of a company's underlying profitability.

Each of these adjustments can have a significant impact on a company's reported earnings. By making these adjustments, traders can get a more accurate picture of a company's true earning power.

Limitations of Normalised Earnings

While normalised earnings can provide a more accurate picture of a company's ongoing operations, they are not without their limitations. One of the main limitations is that there is no standard method for calculating normalised earnings. This means that different traders may come up with different figures for the same company, depending on the adjustments they make.

Another limitation is that normalised earnings can be manipulated. For example, a company might classify certain expenses as non-recurring in order to boost its normalised earnings. This is why it's important for traders to carefully review a company's financial statements and understand the adjustments that have been made.

How to Use Normalised Earnings in Trading

Normalised earnings can be a valuable tool for traders. They can be used to assess a company's future earnings potential, to compare the financial performance of different companies, and to identify trading opportunities. However, like any financial metric, they should not be used in isolation.

Traders should also consider other financial metrics, such as revenue growth, profit margins, and return on equity. They should also consider non-financial factors, such as a company's competitive position, the quality of its management team, and the overall health of its industry.

Conclusion

In conclusion, normalised earnings are a measure of a company's profitability that excludes unusual or non-recurring items. They provide a more accurate picture of a company's ongoing operations and allow for better comparisons between companies. While they are not without their limitations, they can be a valuable tool for traders when used in conjunction with other financial metrics and non-financial factors.

As with any financial concept, understanding normalised earnings requires practice and experience. By taking the time to understand this concept and how it can be used in trading, you can make more informed trading decisions and improve your chances of success in the markets.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.