The profit and loss statement

The profit and loss statement — also called the income statement — summarizes your business's revenue and expenses over a defined period. It starts with total income, subtracts the cost of goods sold (if applicable), and then subtracts operating expenses to arrive at net profit or net loss.

The P&L is the primary document used in business tax preparation. For a sole proprietor or single-member LLC, the net profit from the P&L flows to Schedule C on the personal return. For an S-Corporation or partnership, it flows to the entity return and then to the owners' K-1s.

The P&L answers the question: did the business make money during this period?

• Revenue: all income earned during the period
• Cost of goods sold: direct costs of producing what you sell (if applicable)
• Gross profit: revenue minus cost of goods sold
• Operating expenses: rent, payroll, software, marketing, professional fees, etc.
• Net profit (or loss): what remains after all expenses

The balance sheet

The balance sheet is a snapshot of your business's financial position at a specific date — typically the last day of the month, quarter, or year. It shows three things: what the business owns (assets), what it owes (liabilities), and the difference between the two (equity).

The balance sheet answers the question: what is the financial position of the business right now?

• Assets: cash, accounts receivable, inventory, equipment, prepaid expenses
• Liabilities: accounts payable, loans, credit card balances, accrued expenses
• Equity: the owner's stake in the business — assets minus liabilities

The fundamental accounting equation is: Assets = Liabilities + Equity. If this equation does not balance, something is wrong with the books.

How they work together

The P&L and balance sheet are connected. The net profit from the P&L flows into the equity section of the balance sheet at the end of each period. If the business earned $50,000 in net profit during the year, the equity section of the balance sheet increases by $50,000 (adjusted for any owner draws or distributions).

A business can show a profit on the P&L and still have cash flow problems — if, for example, customers owe large amounts that have not been collected. The balance sheet reveals this by showing a high accounts receivable balance alongside a low cash balance. The P&L alone would not tell you that.

What business owners should look at regularly

For most small business owners, reviewing the P&L monthly is the most useful habit. It tells you whether revenue is tracking to plan, whether expenses are in line, and whether the business is profitable. It also gives you the information you need to make mid-year tax planning decisions.

The balance sheet is worth reviewing quarterly at minimum — and more frequently if the business carries significant receivables, inventory, or debt. It is also the document a lender or investor will ask for if you ever seek outside financing.

Common misunderstandings

• Confusing profit with cash. A business can be profitable and still run out of cash if collections are slow or expenses are front-loaded.
• Ignoring the balance sheet entirely. For businesses with loans, equipment, or significant receivables, the balance sheet is as important as the P&L.
• Not reconciling the balance sheet. If the balance sheet does not balance, or if account balances do not match actual bank and loan statements, the books have errors that need to be corrected.
• Using cash-basis accounting without understanding its limitations. Cash-basis P&Ls do not show receivables or payables, which means the balance sheet picture is incomplete.