Reading a profit and loss statement for the first time

A profit and loss statement (often called a P&L, or an income statement) is usually the first financial report an owner shares with a serious buyer. It shows the money a company brought in over a period, the money it spent, and what was left.

You don't need to be an accountant to read one. You need to know what each section is telling you, which numbers deserve a second look, and what to ask. This post walks through a small company's P&L from top to bottom.

The shape of every P&L

Whatever the software or the bookkeeper, a P&L follows the same order:

1. Revenue: what customers paid for the company's work or products.
2. Cost of goods sold: what it cost to deliver that work.
3. Gross profit: revenue minus cost of goods sold.
4. Overhead: the costs of running the company, whether or not a job comes in.
5. Net profit: what's left at the bottom.

Here's one year for a hypothetical plumbing company:

Line	Amount
Revenue	$1,800,000
Cost of goods sold (parts, materials, technician wages)	$990,000
Gross profit	$810,000
Office staff	$160,000
Rent	$60,000
Vehicles and fuel	$95,000
Insurance	$55,000
Marketing	$40,000
Phones, software, accounting and other	$45,000
Owner's salary	$120,000
Depreciation	$35,000
Interest	$10,000
Net profit	$190,000

Let's take it section by section.

Revenue: the top line

Revenue is the total the company billed or collected for the period. One year on its own tells you little. Ask for three years, month by month if you can get it, and look for:

• The trend. Growing, flat or sliding? A slide that gets explained away deserves a careful look. Sometimes it simply means an owner nearing retirement has been easing off; see why owners sell.
• Seasonality. Many companies have busy and slow months. That's normal, but you'll need cash to carry you through the slow ones.
• Big one-time jobs. A single large contract can make a year look better than the business really is.
• Where it comes from. Ask for revenue broken out by type (repairs, new installations, maintenance plans) and by customer. If one customer pays a large share of the bills, that's a risk worth understanding.

Also ask whether the P&L is on a cash basis (income counted when the money arrives, costs when they're paid) or an accrual basis (income counted when the work is done, costs when they're owed). Neither is wrong, but a cash-basis P&L can swing from month to month on the timing of a few payments.

Cost of goods sold and gross profit

Cost of goods sold covers the costs that rise and fall with the work: parts, materials, subcontractors and, in many service companies, the wages of the people doing the jobs.

Gross profit is what's left to pay for everything else. In the example, the company keeps $810,000 of its $1,800,000, or about 45 cents of every dollar of revenue. That figure is called the gross margin, and it's one of the most useful on the page, because it shows how well the company prices its work.

What to look for:

• A steady gross margin from year to year is a good sign. A sudden jump or drop needs an explanation.
• Costs that moved between sections. If technician wages sat in cost of goods sold one year and in overhead the next, the gross margin changes even though nothing real did. Ask how costs are sorted, and whether that changed.
• Prices that haven't kept up. If materials got more expensive and the margin shrank, the company may not have raised its prices. That might be something you could fix, but it's your plan, not what you're buying.

Overhead: the cost of keeping the doors open

Overhead (also called operating expenses) covers costs that don't change much with each job: office staff, rent, insurance, vehicles, software, marketing, accounting.

Read each line and ask whether it fits the business you saw:

• Lines that look too low. Rent paid to an owner who also owns the building may be below what a landlord would charge. Almost no marketing may mean the owner brings in work personally. A spouse who keeps the books for free shows up nowhere. All of these can become costs after the sale.
• Lines that look too high. Owners sometimes run personal costs through the business, like a family phone plan or a vehicle that never goes to a job site.
• Big "miscellaneous" or "other" lines. Ask what's in them.
• Lines that appear or disappear. A cost that vanished last year may be one the owner stopped paying ahead of a sale, like equipment upkeep.

Owner pay, depreciation and interest

Three lines need special attention, because they change when the company changes hands.

Owner's pay. In some companies the owner takes a salary that appears as an expense, as in the example. In others the owner simply takes money out, and that doesn't appear on the P&L at all. Ask how the owner gets paid, and how much, so you know whether the profit already covers someone to run the business.

Depreciation. An accounting deduction that spreads the cost of equipment and vehicles over several years. It isn't cash spent this year, but the vans and tools do wear out, so it isn't free either.

Interest. What the seller pays on their own loans. You'll have your own loan, with its own payments.

These three are why buyers rarely judge a company on net profit alone. They look at owner earnings (profit plus what the owner pays themselves, before loan payments and taxes). For the example, a first pass adds the owner's salary, depreciation and interest back to the profit, for about $355,000, before any other adjustments. Which other adjustments are fair is a subject of its own. For now, know that the bottom line isn't the number a price is built on.

Net profit: the bottom line

A low net profit doesn't always mean a weak business. Many owners pay themselves generously and run some personal spending through the company, which lowers profit on paper. A high profit isn't automatically good news either, if it came from skipped maintenance or one unusual year.

The rule that keeps you safe: count only what you can verify. A small company's P&L is usually prepared by the owner or a bookkeeper, and it's rarely audited. Later in your review, you'll compare it with the company's tax returns and bank statements, and they should tell the same story.

Questions to ask about any P&L

• Is this on a cash basis or an accrual basis?
• Who prepares it, and how often?
• Can you share three years side by side, plus this year so far?
• What's included in cost of goods sold, and has that changed?
• How is the owner paid, and where does it show up?
• Are any family members on the payroll, and what do they do?
• Is anything here a one-time item? Is anything missing that a new owner would have to pay for?
• Why did this line change so much from last year?

What to do this week

• If you have a P&L from an owner, put three years in a spreadsheet, side by side.
• Work out the gross margin for each year, and circle any line that changed by a lot.
• Write a question next to every circle. Ask them with curiosity, not suspicion: most odd numbers have an ordinary explanation.
• If you don't have a P&L yet, copy the table above into a spreadsheet and change one line at a time, to get a feel for how each one moves the bottom line.
• Before you rely on any P&L for an offer, have an accountant who works on business purchases go through it with you.