How to read a profit and loss statement when you're buying a business
Short answer
Read a P&L from the top: revenue (what customers paid), cost of goods sold (direct costs of delivering it), gross profit and gross margin, operating expenses (labor, rent, marketing, everything else), and net profit. Then compare each line over three years and as a percentage of revenue. Changes in percentages tell you more than the totals.
A P&L is the seller's document, so confirm it against tax returns and bank deposits before you rely on it.
If you've never read a P&L closely, it can look like a wall of numbers. It's really a short story told in the same order every time: money in, direct costs, overhead, what's left.
The structure
What to look at on each line
| Line | Questions to ask |
|---|---|
| Revenue | Growing or shrinking? By product, customer or location? Does it match the bank? |
| Cost of goods sold | Which costs are included? Is direct labor in COGS or in wages below? |
| Gross margin | Stable? Falling margin = costs up or prices down. |
| Wages | As a percent of revenue, rising? Who's on payroll (including family)? |
| Rent | Who's the landlord? Market rate? Escalations coming? |
| Marketing | Cut recently? Revenue may follow later. |
| Repairs | Unusually low (deferred) or high ("one-time")? |
| Owner-related lines | Officer pay, vehicles, travel, insurance: add-back candidates. |
| Other income | One-time items to remove. |
The percentage view
Illustrative example, not a real business
Revenue grew from $900,000 to $1,000,000 (11%), but cost of goods sold went from $360,000 (40% of revenue) to $450,000 (45%). Gross margin fell from 60% to 55%. Revenue growth was bought with lower margins, perhaps discounts or rising supplier prices. That's a question for the seller, and it doesn't show up if you only look at totals.
Worked example: what changed between two years
Illustrative example continued, not a real business
Put the two years side by side as percentages of revenue. Revenue: $900,000 to $1,000,000. Cost of goods: 40% to 45%. Wages: 22% ($198,000) to 20% ($200,000). Rent: 8% ($72,000) to 7.2% ($72,000). Repairs and maintenance: 2% ($18,000) to 0.5% ($5,000). Marketing: 3% ($27,000) to 1% ($10,000). Say reported net profit went from $135,000 to $160,000. Part of that rise came from repairs falling by $13,000 and marketing by $17,000: $30,000 of savings that may simply be spending the seller postponed before listing. Meanwhile gross margin fell 5 points, which on $1,000,000 of revenue is $50,000 of gross profit lost to costs or discounts. Rising profit, weakening business. The percentage view is how you see it.
Red flags on a P&L
- Gross margin falling while revenue grows: discounting or rising costs.
- Repairs, maintenance or marketing cut sharply in the year before sale.
- No owner salary line at all (in a corporation), or one that changed sharply.
- "Other income" that's large or one-time: insurance proceeds, grants, asset sales.
- Expenses lumped into "miscellaneous" or "general and administrative" with no detail.
- Monthly P&Ls that don't add up to the annual total or the tax return.
Then verify
A P&L is a summary the seller prepared. Reconcile it to the tax return (tax returns vs P&L) and to bank deposits (proof of cash), and mark up the add-backs (add-backs on a P&L).
Cash basis vs accrual: why two P&Ls disagree
Many small businesses keep books on a cash basis: revenue when money arrives, expenses when they're paid. Others use accrual: revenue when earned, expenses when incurred. The same business can show different profits under each, especially around year-end, when a big December invoice collected in January moves revenue from one year to the next. Ask which basis the P&L and the tax return use, and look for changes in method between years. For your analysis, consistency matters more than which method is used. If the seller's internal P&L is accrual and the tax return is cash, reconcile the two before you compare years.
Trailing twelve months (TTM): building the most recent year yourself
Trailing twelve months (TTM) means the most recent 12 consecutive months, regardless of the fiscal year. TTM revenue = last full fiscal year + year-to-date this year − the same year-to-date period last year. It shows whether the business is growing or shrinking right now, which a fiscal year that ended many months ago can hide.
Build it from monthly P&Ls, then check those months against bank deposits.
If a business's fiscal year ended in December and you're looking at it in October, the latest tax return is ten months old. A lot can happen in ten months. TTM closes that gap.
How to calculate it
Illustrative example, not a real business
Fiscal year (Jan to Dec) revenue last year: $1,200,000. January to September this year: $980,000. January to September last year: $890,000.
TTM revenue (October last year to September this year) = $1,200,000 + $980,000 − $890,000 = $1,290,000, up about 7.5% on the last fiscal year.
Why it matters
- Trend. A business that's shrinking this year can still show a good last fiscal year. TTM reveals it.
- Seasonality. Comparing year-to-date with the same months last year removes seasonal effects; comparing with a full year doesn't.
- Recent changes. A lost customer, a price increase or a new competitor shows up in TTM first.
Checks to run
- Get monthly P&Ls for at least 24 months plus year to date.
- Build TTM revenue and SDE, and the same for the prior TTM, to see the trend.
- Check each month's revenue against bank deposits (see proof of cash).
- Watch for unusual last-quarter jumps just before listing.
Lines that mean something different in a small business
Small business P&Ls are usually prepared for taxes, not for buyers. A few lines need translating before you can trust them:
| Line | What it often hides | What to ask for |
|---|---|---|
| Officer or owner compensation | Pay set for tax reasons, not market pay for the job | The owner's actual role and hours |
| Rent | Rent paid to the owner's own property company | The lease and the market rent |
| Auto and travel | Personal vehicles and trips | A list of vehicles and who uses them |
| Repairs and maintenance | Capital spending expensed, or repairs put off | Invoices over a set amount |
| Other income | One-off gains, rebates, insurance payouts, grants | A breakdown by item |
| Contract labor | Workers who may be employees | The contractor list and what each does |
| Interest and depreciation | Debt and equipment the buyer must replace | The loan schedule and fixed asset register |
Each line you translate is a line in your SDE rebuild, adding back or taking away from the seller's figure.
Monthly P&Ls tell you more than annual ones
An annual P&L hides timing. Ask for monthly P&Ls for at least two years. Look for months where revenue jumps or margins change for no obvious reason, expenses that appear only at year-end (often accountant adjustments), and a strong final quarter before a sale, which can be a sign of pulled-forward sales or delayed spending. Seasonal businesses need monthly figures for cash planning anyway, so the request is easy to justify.
Ask who prepared each P&L and how. Statements from the bookkeeping system, a CPA compilation and a spreadsheet the owner typed can disagree, and you should know which you are reading.
Frequently asked questions
What is gross margin?
Gross profit divided by revenue. It shows how much of each sales dollar is left after direct costs. A falling gross margin can mean rising costs or discounting.
What should I compare year to year?
Revenue growth, gross margin, labor as a percentage of revenue, rent, and any line that changes sharply. Ask about every big change.
What's the difference between a P&L and a cash flow statement?
The P&L shows revenue and expenses for a period (on a cash or accrual basis). A cash flow statement shows actual cash in and out, including loan payments and equipment purchases that don't appear as expenses.
How many years of P&Ls should I ask for?
Three full years plus year to date, monthly if possible, and the same months of the prior year for comparison.
How do you calculate TTM?
Take the last full fiscal year, add the year-to-date figures for the current year, and subtract the year-to-date figures for the same months of the prior year. Or simply add up the last 12 months of monthly figures.
Why do lenders look at TTM?
To see current performance between tax years. The SBA SOP requires lenders to analyze the most current interim statements and the comparable prior-year interim, and a required QoE's cash proof covers TTM as well as two fiscal years.
Sources
- IRS Publication 535, Business Expenses
- SBA: Buy an existing business or franchise
- SBA SOP 50 10 8.1, Appendix 15 (interim and comparable interim statements; TTM cash proof)
- IRS: About Schedule C (sole proprietor profit or loss)
- IRS: About Form 1120-S
- IRS Publication 946 (depreciation)
Related guides
General information, not legal, tax, financial or investment advice. Rules and lender practices change; check the linked sources and talk to your attorney, CPA and lender about your deal. Examples with named numbers are illustrations, not real businesses. OKtoBuy's Deal Check does not value businesses or give price opinions.