Reading a Small Business's Financials Before You Buy

Read the income statement for what the business earns, the balance sheet for what it owns and owes, the cash flow for where cash really goes, and the tax returns and bank statements to check all three. Then ask an accountant to test the add-backs, which are the adjustments that turn the seller's reported profit into the earnings you are paying for. Insurance shows up in several places, including premium expense, prepaid insurance, workers' compensation audit balances, claims paid and one-time recoveries. This guide is for buyers who are new to deal financials, and it is general information: your certified public accountant (CPA) should do the analysis.

The short answer

Start with three views of the same year: the seller's profit and loss statement, the tax return and the bank statements. Differences between them are where the questions are.
Earnings are usually stated in seller's discretionary earnings (SDE) for owner-operated businesses or earnings before interest, taxes, depreciation and amortization (EBITDA) for larger ones. Definitions vary by advisor, so ask what is inside each number.
Every add-back is a claim. Ask for the invoice, payroll record or bank entry behind it, and decide whether the cost will really go away under you.
Insurance expense, prepaid insurance, audit accruals, deductible claims and insurance recoveries can all distort earnings. A low premium may mean the seller carried too little coverage, not that the business is cheap to insure.
If you use a Small Business Administration (SBA) loan, the lender calculates debt service coverage from EBITDA, and SBA's rulebook effective October 1, 2026 requires a quality of earnings report for 7(a) first acquisitions and business expansions when the business purchase price is $3 million or more (excluding owner-occupied real estate).

Which financial documents will I get, and what does each show?

A seller usually gives you several years of statements prepared by an accountant or the owner, plus tax returns and internal reports. Each document answers a different question. The table shows what to ask of each and where insurance appears. Use it as a map, and let your accountant do the analysis.

Financial documents and what to look for
Document	What it shows	What to look for	Where insurance shows up
Income statement (profit and loss statement)	Revenue, costs and profit over a period	Revenue by customer or product (is one customer a large share?), the gross margin trend, whether owner pay and family pay are in the cost lines, any month that looks unlike the others, and large one-time items	Insurance expense line, workers' compensation inside labor costs, claims paid, insurance recoveries recorded as income
Balance sheet	What the business owns and owes on one date	Receivables aging (how long customers take to pay), deferred revenue and customer deposits (cash already received for work not yet done), unpaid payroll or sales taxes, owner loans, and working capital	Prepaid insurance, accrued audit premium, accrued claims or deductibles, premium finance balances
Cash flow statement	Where cash came from and went	Whether profit turns into cash. Some small businesses do not produce one, so a CPA may build one from the other statements	Premium payments by installment, financed premiums, large claim payments
Tax returns	What the business reported to the Internal Revenue Service (IRS)	Whether revenue and profit match the statements, and how depreciation and owner pay are treated	Insurance deductions that may include the owner's personal policies
Bank statements	Actual cash in and out	Whether deposits support the revenue figures, and who is paid	Premium payees, claim checks, refunds from carriers
Payroll reports	Wages, headcount and payroll taxes	Whether payroll matches the books, including family members and owner pay	The payroll base the workers' compensation premium is built on
Insurance records	Policies, loss runs and renewal history	Claims history, coverage lines, limits and cost trend	The source for restating insurance cost. See documents for an insurance review

Also check inventory, equipment, and lease and equipment debt.

Ask for several years, not one, and ask for the most recent months so that you can see a trailing twelve months figure. A single good year, or a sharp change right before the sale, is worth an explanation.

Deal structure changes which balance sheet lines matter. In an asset purchase you usually choose which of these items you buy, so ask which balance sheet lines are in the deal. See working capital peg explained.

Why can the tax return and the internal books disagree?

They are built for different purposes. Tax returns follow tax rules. Internal books follow whatever the owner or bookkeeper found useful. The IRS describes two common accounting methods: cash, which records income and expenses when money moves, and accrual, which records them when they are earned or incurred. In practice, owners often run management reports on a different basis than the tax return (for example accrual-style monthly reports and a cash-basis return), and the accountant reconciles the two. Depreciation, owner pay, personal expenses run through the business, and timing of large bills can all differ between the two.

Differences are not proof of a problem, but each one needs a reason. When SBA requires a quality of earnings (QoE) report, the independent financial professional must reconcile the accountant-prepared statements, tax returns, internal financials and IRS transcripts to a normalized earnings figure. The work includes a cash proof, which rebuilds cash receipts and disbursements from bank statements and ties them to the income statement and the tax return. Even if you are not required to do this, the idea is the right one: check each year three ways. See what a quality of earnings report is.

What are add-backs, and how do I test them?

An add-back raises reported profit because a cost was personal, unusual or will not continue. Ask for the invoice, payroll record or bank entry behind each one, and decide whether the cost will really go away under you. Each add-back raises the earnings you are paying for, so each should be supportable. Definitions of SDE and EBITDA vary by advisor, so ask for the exact formula. See what a quality of earnings report is for the categories and how small businesses are valued for the valuation context.

An adjustment can also work against you. Quality of earnings providers commonly treat a one-time insurance recovery as a non-recurring gain and an uninsured casualty loss as a one-time loss, but treatment depends on the engagement and the facts. Ask your CPA how each item should be handled in your numbers. Some quality of earnings providers also restate insurance cost across the years they review, but not all do, so ask whether it is in scope. See insurance in your quality of earnings review for the insurance restatement.

Where do insurance expense and claims show up in the numbers?

Insurance appears in several places, and each can mislead if read alone.

Premium expense. A low figure can reflect a thin program, high deductibles, a premium that has not yet been audited or a discount the seller will lose. It does not show whether coverage was adequate. See why an underinsured seller overstates true EBITDA.
Labor cost. Workers' compensation premium is an estimate. The final premium is set after the policy ends using actual payroll and class codes, and the insurer can audit records for up to three years afterward. Look for an audit balance that was not accrued.
Who pays an audit balance. In a stock purchase it usually stays with the company you buy, and in an asset purchase it normally stays with the seller on the seller's policy. The purchase agreement decides who bears the cost, so ask counsel.
Prepaid insurance on the balance sheet. Prepaid premium is an asset on the seller's books. In a stock purchase the policy stays with the company, so the balance has value to you. In an asset purchase the seller's policies generally do not move to you and cancellation refunds usually go to the seller, so ask counsel whether prepaid insurance belongs in the working capital target at all. See working capital peg explained.
Claims and deductibles. Claims the business paid itself reduce profit in the year they happen. If they recur, they are part of the cost of doing business.
Recoveries. A large insurance payment in a single year can inflate that year's profit. If the seller already added back the related loss, ask the accountant to make sure the loss and the recovery are not double counted.

For a deeper look, read how to read loss runs. Getting a broker's view of what the business should carry before closing helps your financial model use realistic costs.

What does it look like when the three views of a year disagree?

A hypothetical example. A seller's profit and loss statement shows $1,000,000 of revenue. The tax return shows $940,000 and the year's bank deposits total $945,000. The seller explains that $60,000 of December invoices were collected in January, which a cash-basis return counts in the next year. The accountant checks the January deposits against those invoices and what was carried in from the prior year, then asks about the remaining $5,000 gap, which could be a carrier refund, a customer deposit or an owner transfer. Each of the three views now has a reason for its number.

Hypothetical three-way check (illustrative figures only)
View	Revenue shown	Question to ask
Profit and loss statement	$1,000,000	Which basis is it on, and does it include December invoices not yet paid?
Tax return	$940,000	Is it cash basis, and does the $60,000 gap match the January collections?
Bank deposits	$945,000	What is the remaining $5,000, and who sent it?

The lesson is that every number needs a reason before you rely on it. Lenders care too, because the earnings figure also decides how much debt the business can carry.

SBA measures this as historical debt service coverage: EBITDA divided by the combined debt service after the transaction. The minimum is 1.25 to 1 for an initial acquisition and 1.15 to 1 for a business expansion, and lenders may adjust for discretionary expenses, non-recurring income and ownership compensation. The restated earnings, including the insurance side, are covered in insurance in your quality of earnings review.

What should I ask the seller, my accountant and my lender?

Use these questions as an agenda for diligence.

The seller: What changed in the last two years? Which costs are personal? How is revenue recorded, and when? Are there customers, claims or credits that distorted a year?
Your accountant: Do the statements, tax returns, bank deposits and payroll agree? Which add-backs are supported? What does earnings look like on your own cost structure? Do we need a QoE report, and who will use it?
Your lender: Which earnings measure and which adjustments will you use for debt service? Is a QoE required? For 7(a) first acquisitions and business expansions, SBA's rulebook effective October 1, 2026 requires one at a business purchase price of $3 million or more, and below that a buyer, investor or lender may still want one. SBA lets the lender pass the cost to the borrower, and money spent on it can count toward the equity injection, so ask how your lender treats it.
Your broker: What would the business need to carry, and what would it cost?

See the due diligence checklist for buying a small business for the wider list. A Morrow review can compare the policies, loss runs and contracts you send with the business you are buying and request indicative quotes for the program it needs, which your accountant can use in the restatement. Quotes depend on carrier underwriting and are not coverage. Morrow does not provide accounting, valuation or financing advice.

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Frequently asked questions

What financial statements should I ask for when buying a small business?

Ask for several years of income statements and balance sheets, the matching tax returns, recent bank statements, payroll reports and the internal monthly reports the owner uses. Add the insurance policies and loss runs so your advisors can test insurance cost and claims.

Why do the seller's profit numbers not match the tax return?

Tax returns follow tax rules, while internal books follow whatever method the owner used. Cash versus accrual timing, depreciation, personal expenses and one-time items can all differ. Each difference needs an explanation, and your accountant should reconcile them.

What is an add-back, and is it reliable?

An add-back is an adjustment that raises reported profit because a cost was personal, unusual or will not continue. It is only as reliable as the evidence behind it. Ask for records, and decide whether the cost will really disappear under your ownership.

Does a low insurance expense mean the business is cheap to insure?

Not necessarily. It may reflect thin coverage, high deductibles or a premium that was not yet audited. Ask a broker what the business should carry and price that, then restate earnings before you rely on the seller's figure.

Do I need a quality of earnings report?

SBA's rulebook effective October 1, 2026 requires one for first acquisitions and business expansions financed with a 7(a) loan when the business purchase price is $3 million or more. Below that, ask whether your lender, investors or your own risk tolerance call for one. Your accountant can help decide.

References

Just bought a business? Get your insurance reviewed.

Send Morrow the declarations pages, loss runs and key contracts you inherited. Morrow can review them against the business you bought, flag gaps and request quotes where it makes sense. Any new terms depend on carrier underwriting.

Request a review Check a contract

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This article is general information, not legal, tax or financial advice, and not a coverage determination. Coverage depends on the actual policy wording, carrier underwriting, your purchase agreement and your contracts. Ask your attorney and accountant about deal and legal questions.

Reading a Small Business's Financial Statements Before You Buy