How to analyze a business before you buy it

You found a listing that looks good. The broker's summary says it earns $300K a year, the price feels almost reasonable, and part of your brain is already rearranging your life around owning it. This is the moment to slow down, because analyzing a business before you buy it is the skill that separates the buyers who build wealth from the buyers who spend years paying for someone else's problems.

Start with two questions

Every deal analysis answers two questions. Fit: is this a business you should own, one that matches your skills, your capital, your location, and the hours you're willing to work? And numbers: does it make money, and is the price connected to reality? A business can pass one and fail the other, and a great HVAC company is still the wrong deal if you live two states away and hate managing technicians. Answer fit first, because it's free and it eliminates half of the listings before you spend an hour on spreadsheets.

Step 1: Verify the earnings are real

Small businesses are usually priced on SDE, or seller's discretionary earnings: the profit plus the owner's salary and perks, which is the total financial benefit one working owner takes out of the business. The listing's SDE number is a claim until you verify it. It's built from add-backs (expenses the seller says a new owner won't have), and add-backs are where optimistic sellers quietly inflate a business's profit. A one-time lawsuit is a fair add-back. A line like "my spouse's salary, but she barely works here" is one you negotiate.

Ask for three years of profit-and-loss statements and three years of business tax returns, then compare them. Sellers rarely overstate income to the IRS, so the tax returns are your anchor. We wrote a full guide to telling legitimate add-backs from inflated ones, because it's the skill that pays off most in deal analysis.

Step 2: Read the trend behind the average

A broker package that says "averages $290K SDE over three years" can describe two very different businesses. One earned $250K, then $290K, then $330K, and the other earned $330K, then $290K, then $250K. The average is the same, but one business is growing and the other is shrinking. You're buying next year's earnings, so the direction matters more than the average.

Lay the years side by side and look at revenue, gross margin, and SDE separately. Revenue up while margin falls means the business is buying growth. Revenue flat while SDE jumps means costs got cut. Ask which ones, because deferred maintenance and gutted advertising both look like profit for one year only.

Step 3: Scan for the deal-killers

Certain problems sink more deals than everything else combined: one customer who is 40% of revenue, a business that can't run a week without the seller, a lease with two years left and no renewal option, cash revenue the books can't prove. None of these are always fatal, but every one of them changes what the business is worth and what you should ask for in the deal. The full list, and what to do when you spot each one, is in our guide to red flags when buying a small business.

Step 4: Test the price against the debt

Most first-time buyers skip this test. Whether a price is good or bad depends on what the business earns after the loan payments. Lenders call this the DSCR, the debt-service coverage ratio: the business's cash flow divided by the annual loan payments. SBA lenders underwrite to a floor of about 1.15 and most want about 1.25 on an acquisition, so a deal between the two is financeable but thin.

For a worked example, say a business earns $240K in SDE and the asking price is $850K. You buy it with an SBA loan: 10% down, with roughly $765K financed over 10 years at 9.75% (the SBA's rate cap for a loan this size at today's Prime). The payments come to about $120K a year. Take out a fair salary for the manager the business needs (you), say $90K, and the cash flow left to cover that $120K of debt is about $150K. That's a DSCR of almost exactly 1.25, which is the line most lenders want, with zero cushion. The deal pencils, but barely. One soft month or one optimistic add-back would be enough to make it fail. The price, the down payment, or the structure still has to move to give you real margin, and that's arithmetic you can show a seller. (Terms vary by lender and by year. The SBA's 7(a) program page has the current rules, and your lender will have their own overlay.)

The full pricing walkthrough (SDE first, multiple second, this lender math last) is in how to value a small business you want to buy, and the free does-it-pencil check runs this exact test on any listing in about a minute.

Step 5: Ask before you assume

By this point you'll have a list of things the documents can't answer: why revenue dipped in year two, who manages the crews day to day, and what happens to the two biggest accounts when the seller's name comes off the door. That list is worth having. Analysis also means knowing what to ask the seller before you make an offer, and paying attention to which questions get straight answers and which get stories. Notice whether the seller welcomes hard questions or avoids them, because either one tells you something.

What this looks like in practice

Screen for fit in minutes, run steps one through four in an evening or two, and only then invest real weeks (and real money for a CPA and attorney) in the deals that survive. Stay excited, because buying the right business is one of the best financial moves a regular person can make. But make every deal prove itself. Scope the numbers before you fall for the story, and you'll walk away from the bad deals with your capital and your confidence intact.

FAQ

How long does it take to analyze a business before buying it?

A first screen (fit, rough numbers, obvious risks) should take a few hours. Full due diligence after an accepted offer typically runs 30 to 90 days. The expensive mistake is spending diligence-level weeks on deals a one-evening screen would have eliminated.

What financial documents should I ask for?

At minimum, ask for three years of P&Ls, three years of business tax returns, a current balance sheet, and the seller's add-back list. The tax returns are the anchor, so compare everything else against them.

Can I analyze a business myself, or do I need an accountant?

Do the first screen yourself. It's how you learn the business, and it keeps you from paying professionals to evaluate deals that were never real. Bring in a CPA before you close, and consider a quality-of-earnings review on larger deals. None of this article is advice for your specific deal, so confirm the specifics with your own CPA and attorney.

What is a good DSCR when buying a business?

About 1.15 is the floor SBA lenders underwrite to, and most want about 1.25 on an acquisition, meaning cash flow covers the loan payments 1.25 times over. Between 1.15 and 1.25, the deal is financeable but thin. Under 1.15, expect the lender to push for a lower price, more down, or seller financing on standby.

Educational content, not financial, legal, or tax advice for your situation. Confirm specifics with your own CPA and attorney. Written by Mark Higbee, Scope co-founder, who is going through the buying process himself.