Why Buyers Must Read the Financials
The financial statements are where the truth about a business lives. As a buyer, you are purchasing future cash flow, so you must be able to read what the business actually earns, owns, and owes. You don't need to be a CPA — and you should use one — but understanding the three core statements lets you spot value and risk before you ever make an offer.
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The Profit & Loss Statement (P&L)
The P&L (or income statement) shows performance over a period. Read it top to bottom:
- Revenue — total sales; check whether it's recurring or one-time and the trend over three years
- Cost of goods sold (COGS) — the direct cost of what's sold
- Gross profit / margin — revenue minus COGS; margin stability matters
- Operating expenses — rent, payroll, marketing, overhead
- Net income — what's left after all expenses
For small businesses, net income alone understates the owner's true benefit — which is why buyers convert it to SDE (below).
The Balance Sheet
The balance sheet is a snapshot of what the business owns and owes at a point in time: assets (cash, receivables, inventory, equipment), liabilities (payables, debt), and equity (the difference). For buyers it reveals working-capital needs, debt to be dealt with at closing, the condition and value of assets, and any liens. In an asset sale you often don't assume the seller's debt, but the balance sheet still informs working capital and asset value.
The Cash Flow Statement
Profit is not the same as cash. The cash flow statement shows how cash actually moved — from operations, investing, and financing. A business can look profitable on the P&L yet be starved for cash because of receivables, inventory, or debt payments. Buyers care intensely about cash flow because it's what services acquisition debt and pays the owner.
From Net Income to SDE and EBITDA
Small businesses are valued on Seller's Discretionary Earnings (SDE), not raw net income. To get there, you add back to net income: the owner's salary and benefits, personal expenses run through the business, interest, depreciation, amortization, and any one-time or non-recurring costs. Larger businesses use EBITDA (which doesn't add back owner pay). Your job in due diligence is to confirm every add-back is legitimate — inflated add-backs are the most common way asking prices get puffed up.
Red Flags in the Statements
- Financials that don't reconcile with tax returns — a major warning sign
- Aggressive or unexplained add-backs inflating SDE
- Declining revenue or shrinking margins
- Heavy cash sales that can't be verified
- A sudden earnings jump right before the sale
- Rising receivables or aging inventory masking collection problems
Always compare internal statements against filed tax returns — the returns are what the owner told the IRS, and they're a crucial reality check.
Frequently Asked Questions
What financial statements do I need to buy a business?
The three core statements: the profit and loss statement (income statement), the balance sheet, and the cash flow statement, ideally three years of each, plus the business's filed tax returns. Comparing internal statements against tax returns is an essential reality check on the reported earnings.
What is the difference between net income and SDE?
Net income is what remains after all expenses on the P&L. SDE (Seller's Discretionary Earnings) adds back the owner's salary and benefits, personal expenses run through the business, interest, depreciation, amortization, and one-time costs, to show the true economic benefit to a working owner. Small businesses are valued on SDE, not raw net income.
How do I know if a seller's financials are accurate?
Compare the internal profit and loss statements against filed tax returns and bank statements, they should tell the same story. Scrutinize the add-backs, check that revenue is real and collectible, and involve a CPA in due diligence. Financials that don't reconcile with tax returns are a serious red flag.
Do I need to be an accountant to buy a business?
No, but you need to read the basic statements and understand SDE. You should also work with a CPA during due diligence to verify the earnings are real. Understanding the P&L, balance sheet, and cash flow lets you evaluate a business and spot risks before making an offer.
Need Help Reading a Business's Numbers?
Martin Navarro helps buyers understand the financials and separate real earnings from inflated ones. Let's review the business you're considering, confidentially and with no obligation.
Request a Buyer Consultation Call or text: 818-633-3254 · 365navarro.martin@gmail.com