Understanding Your Profit & Loss Statement (Plain English)

The bank balance went up. The report says you lost money. Or the report says you made money and the account cannot cover rent.

Those two results can both be true. A profit and loss statement covers a period of time. It is not the cash in the account on a Tuesday. IRS Publication 583 says an income statement shows the income and the expenses of the business for a given period. A balance sheet shows assets and liabilities and equity on a given date.

What is a P&L

What is a P&L is a performance report for a stretch of time. AccountingCoach lists the other names. Income statement. Statement of operations. Statement of earnings. Profit and loss statement. Income statement basics and the P&L are the same report.

SCORE’s income-statement article says the report tells the story of the business for a month or a quarter or a year. It shows revenue after expenses and losses. IRS Publication 583 says you use it to see whether the business is improving and which items are selling and what you need to change. The same records help you talk with a bank or a creditor.

The heading locks the period. AccountingCoach says a U.S. year can be the calendar year. It can be a fiscal year that ends on another date. Some retailers use a 52-week year and a 53-week year every six years. Their “months” can be four weeks or five weeks. If you compare this March with last March, confirm both headings cover the same kind of period.

How to read a P&L statement

Read a P&L statement from the top down. This is a profit and loss statement explained in that order. Forbes Advisor puts the small-business lines here.

P&L plain English for that last line is the bottom line. AccountingCoach calls net income the bottom line after income tax expense on a corporation’s statement. If the number is positive, SCORE says the business is doing OK and you should look deeper when it is negative. SCORE says a loss is common for a business that is starting out.

That “OK” is not a full diagnosis. A positive bottom line can hide a weak gross profit or a one-time gain or owner pay that never hit the report. The sections below are what to check.

Sales and returns

For a company that sells goods, AccountingCoach says the first operating-revenue line is net sales. Start with the amount billed. Subtract returns. Subtract allowances. Subtract discounts the customer earned by paying inside a discount window.

A service business uses a different top line. AccountingCoach says its operating revenue is service fees or service revenue. Its direct cost is the cost of services, not the cost of goods.

Sales of the product belong in operating revenue. Selling an old truck does not, if you are not in the truck business. AccountingCoach says that cash is not net sales. SCORE lists a gain on land or an old vehicle as money from outside the core work. Only the gain or the loss belongs on the report. The full sale price does not.

Cost of goods sold and gross profit

Profit and loss for small business owners who sell products turns on this section. AccountingCoach says cost of sales is the cost of the products sold during the period in the heading. It is the dominant operating expense for a product company. AccountingCoach puts that cost at 60 to 80 percent of net sales in many cases. No other operating expense comes close. The figure has to be right.

A retailer’s cost is the supplier price plus the cost to get the item ready for sale. AccountingCoach’s example is a product bought for three hundred dollars with twenty dollars of shipping. The cost of that product is three hundred twenty dollars.

A manufacturer’s cost is the cost to produce the goods that sold. That includes raw materials and direct labor and manufacturing overhead for those items. AccountingCoach says splitting the overhead across the goods is the hard part.

Gross profit is net sales minus cost of sales. SCORE uses the same subtraction and calls it the profit from that step. It is not the final profit. AccountingCoach says gross profit must cover selling and general and administrative expenses plus nonoperating items such as interest. Otherwise net income cannot be positive.

Gross margin is gross profit divided by net sales. AccountingCoach says the percent shows whether selling prices and the gross profit rate held. You can compare it with a prior period of the same length. Supplier price increases and price pressure and inflation make that rate hard to hold. The sources do not name a “good” percent for every trade.

An inventory mistake lands here. AccountingCoach says a bad count or a bad cost for ending inventory can throw off cost of sales and gross profit and net income together.

Operating costs and everything after

Operating expenses are the costs of the main work that are not the direct cost of the goods or the service. Forbes Advisor’s examples are rent and software and marketing and insurance and utilities. SCORE adds office supplies. AccountingCoach groups a large share of these as selling and general and administrative expenses. Interest on financing sits outside that group for most businesses. It appears after operating income.

Operating income is operating revenue minus operating expenses. AccountingCoach then adds or subtracts items from outside the main work. Investment income. Interest expense. A gain or a loss on equipment you used and then sold.

Income before tax is operating income plus or minus those outside items. Income tax expense on a corporation’s statement is the tax tied to the amounts on that statement. AccountingCoach says the cash you pay can differ because the payment follows the tax return.

SCORE lists depreciation as its own idea. The cost of equipment or a vehicle is spread over time as the asset ages. The pattern depends on the business. AccountingCoach says most income-statement amounts use the original cost. Its illustration is a building put up twenty years ago for seven hundred fifty thousand dollars, with a twenty-five-year life and no salvage value. Each year’s report shows thirty thousand dollars of depreciation. A similar building built today might cost one million five hundred thousand dollars and show sixty thousand dollars of depreciation. This year’s sales are matched with an old cost.

The owner line that changes the bottom line

Understand a P&L by asking who got paid for the owner’s work.

AccountingCoach says a sole proprietorship’s income statement does not show an expense for the owner working in the business. The owner is not paid a salary. Net income mixes two things. Pay for the owner’s labor. Earnings of the business. You cannot set that bottom line next to a corporation that pays the owner a salary and call them the same result.

AccountingCoach’s illustration makes the gap concrete. A sole proprietorship reports one hundred thousand dollars of net income. That figure includes the owner’s work and the business earnings. The same business as a corporation pays the owner eighty thousand dollars of salary. Salary expense brings net income down to twenty thousand dollars. The work did not change. The report did.

SCORE’s income-statement article lists an owner’s draw as the money you take out to pay yourself. That is a different description from AccountingCoach’s salary point. AccountingCoach says sole-proprietor net income increases the owner’s capital account and a loss decreases it. A corporation’s net income increases retained earnings. A loss decreases them. Those accounts sit on the balance sheet. The two reports connect. They do not measure the same day. The income statement is a period. IRS Publication 583 says the balance sheet is a date.

If you run an LLC, these sources do not print one universal owner line. The corporation pattern and the sole-proprietor pattern are the two they describe. Ask your preparer which one matches your tax election before you judge the bottom line.

What to watch

Small business profit and loss reading is a short list, not a hunt for a single ratio.

• The period in the heading. A strong month can sit inside a weak year.
• Net sales versus a one-time gain. A gain on an old truck can change the bottom line without meaning the product sold better.
• Gross profit against operating costs and interest. If gross profit is smaller, AccountingCoach says net income cannot be positive.
• Inventory. A wrong ending count can move cost of sales and the bottom line together.
• Owner pay. A sole proprietor’s profit includes unpaid owner labor. A corporation’s profit is after the owner’s salary.
• Tax on the statement versus tax you paid. AccountingCoach says those amounts can differ for a corporation.
• Cash versus the report. Under accrual, AccountingCoach says a December sale the customer pays in January is December revenue. The receivable sits on the balance sheet until the cash arrives.

The method decides which period gets the sale. IRS Publication 583 says the cash method reports income in the year you receive it. You usually deduct or capitalize expenses in the year you pay them. Under accrual you generally report income when you earn it. You deduct or capitalize expenses when you incur them. You must use the same method to figure taxable income and to keep your books. If inventory is necessary to account for income, the IRS says you generally use an accrual method for purchases and sales. Some small taxpayers can use the cash method. The tests sit in IRS Publication 538. SCORE’s accounting guide says a service business may choose cash and a goods business may choose accrual. Under accrual, SCORE says you may owe tax on income you have not received yet.

SCORE’s accounting guide says to compare what you expected with what happened. It puts a profit and loss projection review on the quarterly list and year-end financials on the yearly list. A P&L next to the forecast shows the gap. A P&L alone shows the result.

How the report gets its numbers

Financial statement basics start in the records. IRS Publication 583 says everyone in business must keep records. The records must clearly show income and expenses. They are generally the same records you use to watch the business and to prepare the return. SCORE’s accounting guide says not to rely on memory. You have to be able to show them if the IRS examines the return.

Forbes Advisor separates two jobs. Bookkeeping records the transactions. Accounting turns those records into reports and decisions. The chart of accounts is the list of categories behind every line on the P&L. Forbes Advisor calls it the financial encyclopedia. Personal costs in the business accounts blur the report. Forbes Advisor says to keep business accounts separate from personal accounts from the start.

SCORE’s copier example shows why the category matters. Pay ten thousand dollars for a copier on the spot and SCORE calls that an expenditure. Pay it off over several years and SCORE calls it an expense.

A single-entry system can produce this report. IRS Publication 583 says single-entry bookkeeping is built on the income statement. It tracks the flow of income and expenses. It can be a simple system when you are starting a small business. IRS Publication 583 says it may not suit everyone.

Reconcile before you trust the lines. Forbes Advisor’s bookkeeping guide lists reconciliation among the core tasks along with recording transactions and handling bills and invoices. Reconciliation is how you confirm the books match the bank before you read the report.

When those categories and the bank activity live in one system, the P&L is a report you can pull for the month in the heading. QuickBooks Online is one place to do that. The software does not decide whether a cost is a direct cost or overhead. You do. Read gross profit before you read the bottom line.

Read the next report this way

1. Check the heading. Name and report and period.
2. Confirm the method. Cash or accrual. IRS Publication 583 says the books and the return use the same one.
3. Note revenue. Separate product or service sales from a one-time gain.
4. Subtract the direct cost. Read gross profit and the percent of sales.
5. Subtract operating costs. Then interest and any gain or loss on old assets.
6. Ask whether owner pay is inside the bottom line or missing from it.
7. Set the result next to the same period last year and next to the forecast. SCORE’s accounting guide is the reason for that comparison.

A one-page printout is enough to start. Read business financials by walking the lines in order. If the report comes from QuickBooks Online, use it after the accounts are reconciled. The bottom line is a result. The lines above it tell you what to change.