How to Read a Profit and Loss Statement
A profit and loss statement (P&L, also called an income statement) is the financial statement you'll read the most, both while evaluating a listing and every month after you own the business. Unlike a balance sheet, which is a snapshot of what a business owns and owes on one day, a P&L covers a stretch of time and answers a simpler question: did the business make money, and how much?
The one idea a P&L is built on
A P&L is a waterfall. Money comes in, costs get subtracted in stages, and what's left at the bottom is profit. Every P&L follows the same basic order:
- Revenue. The total money the business brought in from sales, before any costs are subtracted. On its own, revenue says nothing about profitability.
- Cost of goods sold (COGS). The direct cost of producing or acquiring what the business sold. Subtracting COGS from revenue gives gross profit.
- Operating expenses. Everything else it costs to run the business: marketing, software, contractors, rent, and the owner's own pay if they take one.
- Net profit (net income). What's left after every cost, including interest, taxes and depreciation, is subtracted from revenue. This is the bottom line.
A simple example
| Line item | Amount |
|---|---|
| Revenue | $200,000 |
| Cost of goods sold (COGS) | $60,000 |
| Gross profit | $140,000 |
| Operating expenses | $100,000 |
| Net profit | $40,000 |
| Addbacks | $15,000 |
| Seller's discretionary earnings (SDE) | $55,000 |
Revenue of $200,000 minus $60,000 in COGS and $100,000 in operating expenses leaves $40,000 in net profit. Adding back $15,000 in addbacks brings the total to $55,000 in SDE, the number most small-business sale prices are actually based on.
What addbacks are, and why net profit alone understates the business
Addbacks are expenses on the books that a buyer adds back to net profit because a new owner wouldn't necessarily pay them. The most common ones:
- The current owner's salary or draw. A solo owner sets their own pay however they like, so it tells you nothing about what the business actually generates.
- Personal expenses run through the business. A car, travel, or family members on payroll who don't do real work.
- One-time costs. A legal settlement, a one-off rebrand, or another expense that won't recur under new ownership.
- Non-cash expenses. Depreciation and amortization don't cost cash in the period they're recorded.
Adding these back produces seller's discretionary earnings (SDE), the figure most sub-$5 million business sale prices are quoted as a multiple of. For a larger business that could support a paid, non-owner manager, buyers use EBITDA instead, which only adds back interest, taxes, depreciation and amortization, not the owner's own compensation. Legitimate addbacks reveal what the business actually earns. Inflated or unsupported ones are a common way sellers overstate earnings, which is why a quality of earnings review checks every addback line by line rather than taking the seller's list at face value.
How this differs from a balance sheet and cash flow statement
A P&L covers a period of time, a month, a quarter, or a year, and shows whether the business made money over that stretch. A balance sheet is a snapshot of what the business owns and owes on one specific day. A business can show a healthy net profit on its P&L while its balance sheet carries real debt or a shrinking cash position that the profit number alone would never reveal.
Neither statement fully captures whether cash actually moved in and out. That's what a cash flow statement tracks, since a business can be profitable on paper while still running short on cash if customers pay slowly or expenses land before revenue does. Reading all three together, not just the P&L, is what gives you an honest picture of a business.
What to actually check, as a solo owner
You don't need to analyze every line every month. A handful of numbers tell you most of what matters:
- Revenue trend. Is it growing, flat, or shrinking over the last 12 to 24 months, not just the most recent one?
- Gross margin. Revenue minus COGS, as a percentage of revenue. A shrinking gross margin usually means rising input costs or pricing pressure, even while revenue looks fine.
- The size and nature of addbacks relative to net profit. Addbacks larger than net profit itself aren't automatically a red flag, but they deserve scrutiny. Ask for documentation on anything you can't verify.
- Net profit trend relative to revenue. A business growing revenue while net profit shrinks is spending more to generate each dollar of sales, worth understanding before you buy or before you keep running it the same way.
The takeaway
A P&L is just revenue minus costs, in stages, ending in a bottom line. Once you can trace that waterfall from revenue down to net profit, and understand which addbacks bridge net profit to SDE, you can read almost any small business's financials with real confidence, whether you're evaluating a listing or checking your own numbers every month.