Buying a Small Business – Company Valuation
Analyzing the Income Statement for Purchasing a Business
Oct 11, 2009
There are many considerations when buying a small business. One of the most important considerations is the financial stability and strength of the company that’s being purchased. Analyzing the financial statements enables the buyer to determine the financial position related to their personal investment. The three financial statements that should be analyzed prior to buying a small business are the income statement, balance sheet and the statement of cash flows.
The Income Statement and Buying a Small Business
The profitability of a business is naturally an important consideration. The income statement (a.k.a. profit and loss statement) shows the monthly profitability of the company. The top portion of the statement shows actual gross income. The bottom portion of the statement shows expenses. The bottom line of the profit and loss report should list net profit before taxes. Net profit is income minus expenses.
Before analyzing the income statement, it’s best to have a few previous months statements, as well as previous year-end statements on hand.
The Income Statement- Analyzing Gross Profit
The top portion of the income statement should show all gross income that the company generates. Most businesses will show gross profit as the majority of their income. If the company sells a product, gross profit is the difference between sales and the cost of sales. If the company is a service related business, the gross profit may be total revenues generated by those services. It’s important to understand how the company generates gross profit before analyzing the income statement.
Sales are generally listed on the statement as a reference only. Besides gross profit from sales, other income should also be listed on the upper portion of the report. The statement should also show the percentage of gross profit to sales. Year-to-date totals for sales, gross profit and percentage of gross profit to sales should also be listed.
Reviewing Gross Profit and Income
- Sales – Sales totals don’t have much meaning to profitability other than their relationship to gross profit.
- Gross Profit – Analyze the gross profits in each sales or service category. There may be areas where gross profit is weak and unprofitable.
- Other Income – If other income is listed, it’s important to understand how the income is generated.
- Gross Profit as a Percent of Sales – Look for low percentages, this may an indication of unprofitable sales.
- Year to Date – Look for downward trends in sales and gross profit, this could be an indication of negative business sales and gross profit trends.
The Income Statement- Analyzing Expenses
The bottom portion of the income statement should show the expenses that the company generates. The listed expenses are generally separated into two categories, variable and fixed expenses. This is an important distinction when analyzing the income statement for the following reasons.
- Fixed Expense – Expenses that are fixed are generally consistent from month to month; there’s usually not much that an entrepreneur can do to change fixed expense cost. Some examples of fixed expense are rent, insurance, utilities and insurance.
- Variable Expense – Unlike fixed expense, variable expenses generally fluctuate from month to month. Often times they may increase as gross profit increases, if they are related to generating sales. Some examples of variable expense are salaries, commissions, equipment maintenance, advertising and supplies.
When analyzing expense, fixed expense is generally what can be expected every month. Variable expense on the other hand should be analyzed as a comparison to gross profit. The percentage of expense to gross profit is a good indication of how the expenses are distributed. Look for trends in the percentage of expense to gross profit from month-to-month and year-to-year.
When analyzing the income statement, make sure that the net profit amount is sufficient enough to realize a sufficient return on the initial investment. Besides scrutinizing the profit and loss statement, the balance sheet is an important financial statement for the actual worth of the company. The statement of cash flows is another important report of the company’s ability to generate cash.
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