“Cost-basis” accounting statements such as the company’s Income Statement and Balance Sheet require adjustments before you can use them in business valuation. Your goal here is to demonstrate the business earning power and economic value of its asset base.
Your focus for the Income statement adjustments is to identify discretionary expenses that contribute to the business’ available cash flow. These discretionary adjustments are often called addbacks. You can then use this adjusted cash flow as the earnings basis in valuing the business.
When adjusting the company’s Balance Sheet, you need to determine the market value of the assets. This value may differ considerably from the depreciated book value. In addition, most businesses have a number of “off-balance sheet” assets that are quite valuable. Examples are the internally developed products and services, customer lists, and vendor agreements concluded on favorable terms.
Last, but not least, the business may have considerable goodwill. Business goodwill is not recorded on the accounting Balance Sheet, unless the business was purchased previously.