How to Read a Business P&L When Buying a Company

Most buyers get nervous when they see a profit and loss statement for the first time. It's a page of numbers in a format they've never had to read before. The seller's broker is using acronyms like EBITDA and SDE. The rows don't match what they expected. The net income looks low but the broker is claiming the business is highly profitable.

Here's the thing: the P&L is not that hard to read. Once you understand the structure and know what you're looking for, it becomes one of the most useful tools you have as a buyer. I read P&Ls almost every day, and I've gotten to the point where I can spot the three or four numbers that matter most in about five minutes.

This post walks through how to read a business P&L when you're evaluating an acquisition, what calculations to make, what to compare, and what questions to ask when the numbers raise flags. I'll use real-world examples throughout to make it concrete.

Why the P&L Is Your First Window into a Business

The P&L, also called an income statement, tells you how much money the business made (or lost) over a specific period, usually a year. It shows every dollar that came in and every dollar that went out in the form of expenses, and what's left at the bottom.

As a buyer, the P&L answers your most fundamental question: is this business actually profitable, and how profitable is it really once you strip away the seller's personal expenses?

The P&L is different from the tax return, which is designed to minimize taxable income. It's different from the CIM financials, which are designed to present the business favorably. The best version of P&L analysis looks at all three: the CIM recast financials, the actual P&L from the accounting software, and the filed tax returns. Discrepancies between these three documents are where the most important questions live. For a guide to reading the tax side, see how to read business tax returns before buying.

For a standard small business acquisition, you want three years of P&Ls. One year tells you the snapshot. Two years tells you a comparison. Three years tells you a trend. Anything less than three years is insufficient to understand where the business is going.

Revenue Section: Trends Are More Important Than Totals

The top of the P&L shows revenue, sometimes broken into categories (product sales vs service revenue, for example) and sometimes as a single line.

The first thing you're looking for is not the revenue amount. It's the revenue trend.

A business doing $800,000 in revenue this year that did $700,000 last year and $620,000 two years before that is growing. The trend tells you the business has momentum. A business doing $800,000 this year that did $950,000 last year and $1,100,000 two years ago is declining. The current number looks the same, but these are fundamentally different businesses.

Revenue mix also matters. If a business has 10 clients and one of them accounts for 40% of revenue, that's concentration risk that doesn't show up in the total. Ask the broker or seller to give you a breakdown of revenue by customer or revenue stream, not just the total line.

Watch for unusual revenue spikes in the most recent year. A business that had flat revenue for two years and suddenly showed 30% growth in the year they put it up for sale deserves scrutiny. What drove the growth? Was it repeatable, or was it a one-time contract?

Cost of Goods Sold: What Healthy Margins Look Like by Industry

Cost of goods sold (COGS) is the direct cost of producing whatever the business sells. For a product business, this includes raw materials and manufacturing costs. For a restaurant, this is food and beverage cost. For a service business, COGS is often zero or very small, consisting primarily of direct labor or subcontractor costs.

Gross margin is revenue minus COGS, expressed as a percentage of revenue. Different industries have very different normal ranges:

• Software and digital services: 70% to 90% gross margin
• Service businesses (consulting, cleaning, landscaping): 50% to 75% gross margin
• Wholesale distribution: 20% to 35% gross margin
• Retail: 25% to 55% gross margin (varies widely by category)
• Restaurants: 60% to 70% gross margin (after food cost)
• Manufacturing: 30% to 60% gross margin depending on product type

If a business's gross margin is significantly below its industry norm, one of two things is true: the business has higher-than-average input costs (which is a competitive problem) or there's an expense categorization issue and some things that are really operating expenses are being included in COGS.

If gross margin is significantly above industry norm, that's either a genuine competitive advantage or an accounting presentation that masks true costs. Both possibilities are worth investigating.

Gross Profit: The Number Buyers Calculate First

Gross profit is revenue minus cost of goods sold. It's the money available to cover operating expenses and generate profit for the owner.

I calculate gross profit first because it tells me immediately whether the business is structured to be profitable at all. If a business has $600,000 in revenue and $480,000 in COGS, there's only $120,000 in gross profit to cover rent, salaries, marketing, utilities, and every other operating expense. That's going to be extremely tight for most business types.

If that same $600,000 business has $180,000 in COGS, the $420,000 in gross profit gives it room to be profitable even with significant operating overhead.

Gross profit margin, not revenue, is what determines how well a business can weather expense increases or revenue downturns. A business with high gross margins can absorb a bad month. A business with thin gross margins is always on the edge.

Operating Expenses: What to Look for and What to Question

Operating expenses (OPEX) include everything the business spends that isn't directly tied to producing what it sells. This is where the business pays for rent, employee salaries, utilities, marketing, insurance, equipment maintenance, professional services (accounting, legal), technology, and a dozen other things depending on the business type.

As a buyer, you're reading the operating expenses with two questions in mind: Are these expenses reasonable and appropriate? And are there personal expenses buried in here that wouldn't be your responsibility as the new owner?

For each major expense line, ask yourself: Is this amount consistent with industry norms? Is this expense necessary for a new owner to operate the business? Has this expense been consistent over the past three years, or is there something unusual happening?

Pay close attention to lines labeled "miscellaneous," "other expenses," or unusually large amounts in categories that seem too high. These are often where personal expenses get run through the business.

Some expenses that regularly appear as operating costs in businesses owned and run by the seller but wouldn't apply to a buyer:

• Owner's personal vehicle expenses (car payment, insurance, fuel for personal vehicle)
• Family members' salaries for people who don't actually work in the business
• Personal cell phone expenses
• Personal travel booked as business travel
• Charitable donations made through the business
• Home office expenses in a business with physical premises

Owner's Compensation Buried in Expenses: How to Find It

This is the most important adjustment you'll make to get from net income to SDE.

In most owner-operated businesses, the owner pays themselves a salary or draws. This shows up somewhere in the operating expenses, sometimes as "officer compensation," sometimes as "owner draw," sometimes just mixed in with payroll. The owner may also have health insurance, retirement contributions, and other benefits run through the business.

All of this gets added back to calculate SDE, because as the new owner, you have the choice of what to pay yourself. The SDE represents what the business generates for whoever owns it, before the owner decides how to compensate themselves.

Here's how to find the owner's compensation in the P&L:

1. Look for payroll or salary expense lines. In a smaller business, the owner's salary may be the largest single salary line.
2. Look at officer compensation if the business is incorporated. This is typically the owner's W-2 wages.
3. Check benefits expense. Health insurance for the owner and family is often run through the business.
4. Check retirement plan contributions. SEP-IRA contributions or 401k matches for the owner are common add-backs.

The broker's adjusted financials should already show these add-backs. But verify them yourself. Ask for the actual payroll records or the owner's W-2. If the broker claims the owner took a $60,000 salary but the payroll records show $95,000, the SDE calculation is wrong and the asking price may be inflated.

Unsure how to calculate SDE from a P&L you've received? Contact us for a free consultation and I'll walk through the numbers with you.

EBITDA and SDE: How to Calculate Them from the P&L

Two numbers come up constantly in business acquisitions. You need to know both.

SDE (Seller's Discretionary Earnings) is the most common metric for small businesses under $5 million in value. It's calculated as:

Net income + owner compensation + owner benefits + depreciation and amortization + interest expense + one-time or non-recurring expenses = SDE

SDE represents the total economic benefit to a single full-time owner-operator. It assumes you're working in the business. This is the number most small business valuations are based on.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is more commonly used for larger businesses where a professional management team runs operations and the owner is not working in the business day to day. It's calculated as:

Net income + interest expense + taxes + depreciation + amortization = EBITDA

EBITDA does not add back owner compensation because the assumption is a management team handles operations. For a larger business being sold to a private equity group or a strategic acquirer, EBITDA is the right metric. For a small business where you're buying yourself a job plus income, SDE is more relevant.

Both can be calculated directly from a three-year P&L if you have the right line items. In many small business P&Ls, depreciation is bundled with other items or shown separately. Interest expense appears if the business has debt. Taxes may or may not appear depending on how the business is structured.

Want to understand how these numbers affect your business's value? Use our valuation calculator to model different scenarios.

Looking at how to finance an acquisition once you've verified the financials? Explore your funding options to see what SBA and seller financing options fit your deal.

Year over Year Comparison: How to Read 3 Years of P&Ls Together

Reading three years of P&Ls side by side is where the most valuable insights come from.

Here's what to look for in a three-year comparison:

Revenue growth rate. Is revenue growing? At what rate? Is the growth accelerating, decelerating, or reversing? A business growing at 12% per year has a very different risk profile from one declining at 8% per year.

Margin stability. Are gross margins and net margins consistent year over year? Margins that fluctuate dramatically suggest either volatile input costs, accounting inconsistency, or operational instability. Stable margins are a positive signal.

Expense categories as a percentage of revenue. Look at each major expense line as a percentage of revenue across three years. If rent is 7% in year one, 8% in year two, and 11% in year three without a significant revenue drop, rent is eating more of the business. If payroll runs from 28% to 34% over three years, labor costs are increasing. These trends matter more than the absolute numbers.

One-time items. Look for expenses in any single year that don't repeat. Legal fees from a specific lawsuit, a major equipment repair, a one-time marketing push. These should be identified and added back to normalize earnings.

Owner compensation changes. If the owner's salary jumped significantly in the most recent year before listing, be skeptical. Sellers sometimes increase their salary temporarily to boost the add-back and inflate the SDE calculation. Compare all three years.

When P&Ls and Tax Returns Don't Match

In a perfect world, the P&L from the accounting software and the tax return tell the same story. In the real world, they sometimes don't, and the reasons range from innocent to serious.

Legitimate reasons for differences: Timing differences in how revenue is recognized (accrual vs cash accounting), deductions on the tax return that don't appear in the P&L (like 179 expense elections for equipment), and adjustments made by the accountant when preparing the return.

Concerning reasons for differences: Income that appears in the P&L but not on the tax return (unreported revenue is a legal problem that becomes your problem if you buy the business and the IRS audits the previous years). Expenses on the tax return that never appeared in the P&L. Significant discrepancies in the salary amounts for the owner.

If you notice a gap between the P&L and the tax return that the seller can't explain clearly and quickly, walk away. Unresolved discrepancies between financial records are a deal killer. You're not just buying the current cash flow. You're potentially inheriting the legal and tax exposure that comes from inaccurate or fraudulent reporting.

The standard practice in due diligence is to reconcile the P&L to the tax return for all three years. Your accountant or financial advisor should be doing this as part of their review.

Common Mistakes Buyers Make When Reading P&Ls

Focusing only on net income. Net income at the bottom of the P&L is often not what you'll actually pocket. It reflects the seller's decisions about compensation, benefits, and personal expenses. Always calculate SDE.

Accepting the broker's recast at face value. The broker's adjusted financials are a starting point, not a conclusion. Every add-back needs to be verified against actual documentation. If the broker can't produce backup for an add-back, it may not be real.

Ignoring expense trends. Looking only at the most recent year gives you a snapshot. Three years of expenses shows you whether costs are being controlled or creeping up.

Not asking about large or unusual line items. If there's a $45,000 line item for "consulting fees" in one year that doesn't appear in the others, ask what it is. Could be a one-time cost that gets added back. Could be a related-party payment that won't go away.

Forgetting the balance sheet. The P&L shows income and expenses. The balance sheet shows what the business owns and owes. A business with strong P&L numbers but $400,000 in unpaid trade debt is in a very different position than one with no liabilities.

Questions to Ask the Seller After Reviewing the P&L

After you've done your analysis, here's a list of questions that will tell you a lot about the business and the seller's honesty:

• "Can you walk me through the biggest changes in your expense structure over the last three years?"
• "What's included in the owner compensation add-back, and can you show me the W-2 or payroll records?"
• "Were there any one-time revenue events in the past three years that wouldn't repeat for a new owner?"
• "The tax return shows $X in net income, but the P&L shows $Y. Can you explain the difference?"
• "Is there any revenue that doesn't show up in the P&L?" (This is a direct question about cash transactions.)
• "What's the single biggest cost you expect to increase in the next two years?"
• "Are there any contracts, equipment leases, or software subscriptions that would transfer to a buyer?"

A seller who can answer these questions clearly, with documentation, is a seller who understands their own business and isn't hiding anything. A seller who gets defensive, vague, or avoidant on basic financial questions is giving you important information.

Your Next Steps

If you're currently reviewing a P&L on a business you're evaluating, here's your action plan:

1. Build a simple spreadsheet. Enter three years of revenue, COGS, gross profit, major expense categories, and net income. Calculate gross margin and net margin percentages for each year.

2. Compare to the broker's recast. Take the broker's adjusted SDE and verify each add-back against the actual P&L line items.

3. Identify every number that needs explanation. Don't move forward to LOI until you can explain every significant variance and verify every major add-back.

4. Request the tax returns. Compare the P&L to the tax returns line by line. Resolve any discrepancies before making an offer.

5. Bring in a professional. For any acquisition over $200,000, have a CPA review the financials independently before you commit. The fee is small relative to the stakes. For a complete list of everything you should be reviewing, see the due diligence checklist for business buyers.

Ready to talk through the financials on a specific deal? Contact us for a free consultation and let's work through the numbers together.

Frequently Asked Questions

What's the difference between a P&L and a tax return? A P&L is the business's internal financial report showing all income and expenses for the period. A tax return is the document filed with the IRS, which uses specific tax accounting rules that can differ from the P&L in timing and certain deductions. Both are important, and they should largely agree with each other.

What is SDE and how is it different from net income? SDE (Seller's Discretionary Earnings) is net income adjusted to add back the owner's compensation, personal expenses, depreciation, amortization, and one-time costs. It represents the total economic benefit the business provides to a single working owner. Net income is just what the accounting shows after all expenses, including the owner's salary.

How many years of P&Ls should I request? Request at least three years. Three years shows you the trend, not just the snapshot. If the business is older, you can ask for five years, but three is the minimum standard.

What if the business uses cash accounting? Does that change how I read the P&L? Cash accounting records revenue when received and expenses when paid. Accrual accounting records them when earned or incurred regardless of cash timing. Both are valid, but you need to know which method is being used. Cash basis businesses can have P&Ls that look very different from their economic reality if there are significant receivables or payables.

Should I hire an accountant to review the P&L before I make an offer? Yes, for any serious acquisition. A CPA with small business acquisition experience can verify the calculations, identify inconsistencies, and catch things that a non-accountant would miss. This is money well spent.

What does it mean if a business has no depreciation on its P&L? It may mean the business has no significant fixed assets. It may also mean the owner is using bonus depreciation or section 179 elections on the tax return but not recording depreciation in the P&L. Ask about this specifically during due diligence.