How to read a small business's financials

The seller sends over a folder. There's a profit and loss statement, a balance sheet, three years of tax returns, and a one-page summary the broker put together with a big number on the front. If you've never read a small business's financials before, this is where a lot of buyers quietly panic. Everything looks official, and you have no idea which parts to trust.

You don't need an accounting degree for this. You need to know what each document is telling you and whether the documents agree with each other.

The four documents, and what each one is good for

Ask for all four, three years of each, plus a year-to-date P&L for the current year. If a seller can only produce one of the four, that's information too.

Read the tax returns before the P&L

Almost every buyer opens the P&L first because that's what the broker highlighted. Flip the order and open the tax returns first. Write down three numbers per year: revenue, total expenses, and net income. Do the same from the P&L, then line them up and see whether they match.

Small differences are normal. Many small businesses file taxes on a cash basis but hand you an accrual-basis P&L, and the two count revenue at different moments: cash basis when the money lands, accrual when the work is invoiced. Fiscal years that don't match the calendar cause gaps too. Those are fine, but a seller who can't explain the gap is a problem.

Sellers have a natural incentive to report less income to the IRS and more income to you. So when the P&L runs meaningfully higher than the tax return, you're sometimes being told, politely, that money never made it onto the books. Sellers will even say it out loud: "there's another sixty grand in cash that doesn't show up." Be careful here, because you can't finance income that doesn't exist on paper, an SBA lender won't count it, and you'd be paying real dollars for a number you're asked to take on faith.

Reading the P&L

Once the tax returns give you a baseline, the P&L is where you learn how the business operates. Ask for it month by month instead of only annual totals, because an annual P&L blends the whole year into one number. A monthly P&L shows you seasonality, the month revenue fell off a cliff, and the expense line that stopped in March with no explanation.

Read it in three chunks, starting with revenue at the top: is it growing, flat, or sliding? If it has slid for three years, treat that as a decline no matter how good the seller's explanation sounds. Next comes cost of goods sold, which gives you gross margin (what the business keeps on every dollar it sells). Gross margin is one of the most honest numbers in the packet, because it's hard to fake without the expenses looking strange. If it was 42% two years ago and it's 31% now, something changed, such as pricing pressure, material costs, or a big customer squeezing them, and you need to find out which.

Then come the operating expenses: rent, payroll, insurance, marketing, vehicles, and owner compensation. This is where add-backs live. Because the price is a multiple of adjusted profit, a $10,000 fake add-back adds $30,000 to the price. Read how to tell a legit add-back from an inflated one before you accept anyone's adjusted number.

Also look for what's missing from the expenses. If the seller runs all the sales themselves on a $60,000 salary, and you'd have to hire someone at $90,000 to do that job, the gap comes out of your pocket every year. Nothing on the P&L will flag that, so you have to notice it yourself.

Reading the balance sheet

It's short, and most buyers skim it. Read it anyway, because it answers questions the P&L can't.

• Accounts receivable. Ask for it aged, meaning broken out by 30, 60, 90, and 120+ days. A pile sitting past 90 means the customers are slow, the work is disputed, or somebody's counting revenue that's never arriving.
• Inventory. The number on the page assumes everything is sellable, so walk the shelves. Obsolete stock carries full value on paper until somebody looks at it.
• Payables and debt. You usually buy the assets and leave the liabilities with the seller, so the seller's debt gets paid at closing. Look anyway, because a business stretching its vendors to 90 days has been short on cash.
• Owner loan accounts. This is money the owner put in or pulled out, often for years and often undocumented. It isn't automatically a problem, but you should always ask about it.

Now tie it out

This is the step where you check the documents against each other. Pick one ordinary month instead of the best one, and follow the money across all three documents.

Say it's a landscaping company. The P&L shows $2,100,000 in revenue last year and $310,000 in net profit. After add-backs for the owner's salary, his truck, and a family phone plan, the broker presents $395,000 in SDE. At 3x, that's an asking price around $1,185,000.

Then you open the 1120-S, and it reports $1,940,000 in revenue, a $160,000 gap. That isn't fatal on its own, since it could be cash versus accrual or a December invoice that landed in January. So pull the bank statements for June and add up the deposits. If June's deposits come to $148,000 and the P&L claims $175,000 for the same month, the same pattern is showing up twice, and "timing difference" starts to sound thin.

Now run it forward. If the real revenue is closer to $1.94M and the margin holds, SDE is around $335,000 instead of $395,000. At the same 3x, the business supports about $1,005,000 instead of $1,185,000, so one afternoon with a calculator moved the price $180,000. You didn't lowball anybody, because you can walk the seller through every line of the arithmetic.

What should slow you down

None of these means you should walk away. Each one is a reason to stop and ask the seller about it.

• The financials only exist as PDFs the seller "exported" and can't reproduce from the accounting software.
• Revenue jumps 40% in the most recent year, right before the sale.
• Expenses drop in that same year, so the business gets suspiciously lean right when it's being marketed.
• The P&L runs well ahead of the tax return with no clear explanation.
• Add-backs total more than a third of the profit.
• Round numbers show up everywhere, which is what estimates look like.
• Most important, the seller gets irritated when you ask a normal question about their own business.

Several of those overlap with the red flags that sink deals, and most of them get resolved, one way or the other, in the conversation you have with the seller.

The order of operations

Here's the sequence to follow when the folder lands in your inbox:

• Read the tax returns first. Write down revenue and net income for three years.
• Line the P&L up against them, year by year, and note every gap.
• Get the P&L monthly. Look for seasonality and anything that stops or starts abruptly.
• Calculate gross margin for all three years and ask about any real movement.
• Go through the add-backs one at a time and decide which ones you believe.
• Read the balance sheet for aged receivables, inventory, debt, and owner loans.
• Tie one ordinary month out to the bank statements.
• Send every question this produced to the seller in one batch.

That last step matters more than people expect. A seller who answers eight specific questions clearly is someone you can probably do a deal with, and a seller who gets defensive has told you something the financials couldn't. That's the point of scoping a business before you buy it. You make the numbers prove themselves before you agree to pay for them, and you don't have to become an accountant to do it.

FAQ

What financial documents should I ask a seller for?

Ask for three years of business tax returns, three years of P&Ls, a current year-to-date P&L, three years of balance sheets, and bank statements for at least the most recent twelve months. Add an aged receivables report and a payroll summary if there are employees.

Which is more reliable, the tax return or the P&L?

Generally the tax return, because there are legal consequences for misreporting it. The P&L is more detailed and better for understanding how the business runs, but it's unaudited and easy to adjust. Use the tax return as your anchor and the P&L for the detail.

Do I need an accountant to read a small business's financials?

You don't need one for the first pass. You can do that read yourself and screen out the deals that don't hold up, which is most of them. Once you're serious about one specific business and heading toward an offer, bring in a CPA who has worked on small-business acquisitions.

What if the seller says there's cash income that isn't reported?

Treat it as zero. You can't verify it, an SBA lender won't count it, and paying a multiple for unreported income means paying real money for a number you only have the seller's word for. It also tells you something about how the business has been run.

How far back should I look?

Three years is standard, and five is better if you can get it. One year tells you almost nothing, because you need enough history to know whether this year is the trend or the exception.

Educational content, not financial, legal, or tax advice for your situation. Confirm specifics with your own CPA and attorney.