Income Statement: Understanding Profitability Before You Buy or Sell
An income statement, also called a statement of operations, shows how much money a business made or lost during a specific reporting period. It lists sales revenue, then subtracts expenses to show net profit or loss for that period of time.
This financial statement is different from a balance sheet, which shows what a business owns and owes, and from a cash flow statement, which tracks money in and out. Instead, the income statement focuses on profitability and performance over time.
For prospective buyers, the income statement offers a snapshot of financial health. It helps assess whether sales are strong, direct costs are rising, and if the business is moving in the right direction.
How Income Statements Are Used in Business Sales
Income statements play a role in sales for both sellers and buyers:
Sellers
Before listing a business, sellers often clean up financial statements. This includes separating personal and business financials, adding back owner salary and benefits, and adjusting for one-time or unusual costs. These “normalizing adjustments” help show what the business really earns. The result is seller discretionary earnings (SDE), a key metric which buyers and lenders use to measure cash flow.
Most buyers expect at least three years of financial statements. If records are incomplete or unclear, it’s worth working with a CPA or advisor to prepare clean accurate reports. Even with good numbers, poor documentation can slow down or break a deal.
Buyers
Buyers use income statements to analyze trends and evaluate profitability. They compare year-over-year data, assess margins, and identify risks, such as customer concentration or seasonal swings.
Lenders, especially those for SBA loans, rely on income statements to evaluate financial health. Clean, GAAP-compliant reports improve financing prospects.
Key Components of an Income Statement
An income statement explains how a business earns and spends money. Each line item gives a clearer view of operations.
- Revenue (Top Line): Revenue includes income from core business activities (operating revenue) and other sources (non-operating revenue), such as interest. Recurring revenue signals steady business; one-time revenue doesn’t. Under accrual accounting, income is recorded when earned—not necessarily when received. Some reports also show net sales (after discounts) and earnings per share (EPS) for corporations.
- Cost of Goods Sold (COGS): Also called the cost of sales, COGS includes materials and labor directly tied to production. Subtracting it from the company’s revenue gives gross profit, which shows how efficiently the business delivers its product. Divide gross profit by revenue to get gross margin, a way of checking whether operating activities are profitable.
- Operating Expenses: These include rent, payroll, marketing, and other overhead. Often grouped as selling, general, and administrative expenses (SG&A), they may include owner perks or research and development. These often need adjusting for business sales.
- EBITDA and Net Income: EBITDA (earnings before interest, taxes, depreciation, and amortization) reflects operating performance before non-cash or financing costs. It is commonly used in valuations. Net income—the bottom line—includes everything, including income tax expense, non-operating expenses, and any gains from discontinued operations. But it may not reflect real cash flow.
Income Statement Structure
There are two income statement formats:
- Single-step income statement: Lists total revenue and total expenses, with a simple net profit at the bottom
- Multi-step income statement: Breaks out gross profit, operating income, and other sections—offering more detail for decision-making.
Statements may be prepared monthly or annually. A monthly report tracks short-term performance; an annual report provides a broader view. Most buyers and advisors prefer to see two or three years of reports side by side to catch changes in income, expenses, or margins over time.
For example, if a three-year report shows rising revenue, but flat earnings, it may point to growing costs or operational inefficiencies that need attention.
Buyer Red Flags
- Declining revenue trends: May signal customer loss or market shifts
- Inconsistent profit margins: Can point to poor cost control or pricing issues
- Unusual or excessive owner expenses: May require adjustments to reflect true earnings
- Missing or incomplete records: Suggests weak financial reporting
- Unexplained seasonal fluctuations: May point to cash flow issues or poor planning
- One-time windfalls: Can mislead buyers about sustainable income
How Income Statements Drive Business Valuation
Income statements are the foundation of small business valuation. Most deals use a multiple of SDE or EBITDA, both drawn from the income statement. Strong earnings and solid gross margin often lead to higher multiples.
Sellers use add-backs to remove non-recurring or personal expenses, helping buyers understand true earning potential. Lenders typically review year-end statements and expect GAAP-compliant reporting.
Most sellers work with CPAs, brokers, or advisors to prepare clean income statements. Using a template or accounting software helps ensure consistency and transparency.
Ready to sell or need help preparing your financials? professional in our Business Broker Directory to start planning your exit.