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Normalized earnings are any type of earnings that are adjusted to allow for shifts in the status of the economy. The idea behind this approach to assessing earnings is to determine what type of profit a business would realize if the current up or downward movement of the economy had not occurred. When calculating this type of earnings figure, it is assumed that the period under consideration is abnormal in some fashion, when compared to another period that is used to set the standard.
At times, normalized earnings are a means of removing unusual gains from the financial picture in order to obtain a more accurate assessment of the business. For example, if a business sells a tract of land during a given economic period, this counts as capital gains and has an effect on the bottom line of the corporation. If the desire is to determine what the financial picture of the business would be if the sale had never taken place and the business only had income from sales, the normalizing the earns would reveal this type of information. When this is the case, obtaining the normalized or true earnings requires nothing more than removing any one time generated income, and leaving only the normal income sources on the balance sheet information.
One of the key processes in determining normalized earnings is the establishment of what constitutes usual or standard earnings. Many businesses use earnings data from the last five to ten annual periods, and calculate average annual earnings based on that data. That average is then compared to the calculation for normalized earnings for the current year, making it easy to determine if the company enjoyed a true upswing or downturn in earnings from the sources cited.
The concept of normalized earnings is very important to determining the true financial health of a company. By removing any isolated situations that brought extra income into the picture, it is possible to focus on the ongoing and usual sources of revenue and evaluate their impact on the business. Doing so makes it easier to assess the long-term potential of the business to remain a viable entity, even if no additional unanticipated sources of revenue ever appear. Normalized earnings is also extremely helpful when it comes to preparing annual operating budgets, since the income reflected in the figure is likely to represent the usual and normal flow of revenue. Using this type of earnings information can help the business plan more realistically and thus enhance the chances of ending the upcoming annual period with a balanced budget.
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