How to Read a Profit and Loss Statement (With a Worked Example)

On this page 6 sections

1. What a P&L Measures and What It Leaves Out
2. How to Read a Profit and Loss Statement, Line by Line
3. Processing Fees Belong on Their Own Line
4. Why a Profitable Month Can Leave the Bank Account Low
5. Five Ratios That Turn the P&L Into Decisions
6. Start With One Comparison This Week

Key takeaways

• If you record net deposits as sales, net income stays the same, but the processing fee line disappears and every ratio shifts. Compare your P&L card sales to your processor statement to check.
• Voluntary card tips belong to staff and aren't revenue. Automatic gratuities are different: the IRS treats them as service charges paid out as wages, so they generally go through revenue and then payroll.
• Small businesses that pass the gross receipts test may be allowed to stay on the cash method for inventory for tax purposes, but matching inventory cost to the month it sells gives a more useful monthly P&L.
• If gross margin holds while net margin falls, look at labor, rent and fees before you change prices.

The quickest way to learn how to read a profit and loss statement is to follow its subtotals from top to bottom. Start at net sales, which is what you sold after refunds and discounts. Subtract cost of goods sold to get gross profit, then subtract operating expenses and interest to reach net income. Gross profit tells you whether your prices cover what you sell; net income tells you whether the whole business made money during the period.

The harder skill is spotting lines recorded wrong. A P&L built from bank deposits instead of processor reports can look fine while hiding what card acceptance really costs you.

This article is general information, not accounting or tax advice. Have your bookkeeper or CPA confirm how your specific transactions should be recorded.

What a P&L Measures and What It Leaves Out

The U.S. Small Business Administration describes the income statement, also called the profit and loss statement, as a report of all income and expense accounts over a period of time. Reading it monthly catches problems while you can still fix them.

It won't tell you how much cash you have, and it leaves out money you're holding for someone else, like sales tax owed to the state. Those amounts sit on the balance sheet.

Your accounting method changes what the statement shows. Cash-method books record income and expenses when money moves. Accrual books record them when earned or incurred; IRS Publication 538 says accrual expenses count in the year incurred, regardless of when you pay. That method gives a truer monthly picture for businesses that carry inventory or take deposits, because a sale and its cost land in the same month.

The Inventory Rule Owners Misread

Publication 538 says that if you need inventory to account for your income, you generally must use an accrual method for purchases and sales. Small business taxpayers get an exception. Businesses that pass the gross receipts test can treat inventory as non-incidental materials and supplies and stay on the cash method. The test is indexed to inflation: Baker Tilly's summary of the 2025 rules puts the threshold at $31 million in average annual gross receipts for 2025, up from $30 million in 2024.

People often read that exception as permission to deduct inventory the day they buy it. It isn't. Under the Treasury rules summarized in Treasury Decision 9942, a cash-method business recovers the cost of inventory treated this way when it provides the items to customers or when it pays for them, whichever is later. Stock still on the shelf at year end generally isn't deductible yet.

The month-to-month swings owners see come from bookkeeping, not from the tax rule. If your books expense a $15,000 holiday inventory order in October when you pay for it (an illustrative figure), October looks like a disaster while December looks like a windfall. Matching inventory cost to the month it sells removes that distortion. Many owners keep monthly management books on that basis and let their CPA prepare the tax-basis version. Ask yours whether that split fits.

How to Read a Profit and Loss Statement, Line by Line

The P&L below belongs to a hypothetical gift shop that sells in store and online. All figures are illustrative and don't represent typical results for any industry.

Work Out Net Sales Before Judging Anything

Gross sales is everything rung up before subtractions: $50,000 here. Each channel line should tie to the matching POS or e-commerce report.

Refunds and discounts come off to reach net sales of $47,500, the revenue the shop actually earned. Give each its own line. A rising refund line warns of product or shipping problems, and you lose that warning if refunds are netted out of sales. Mistakes caught before the batch settles can usually be voided instead; our explainer on void vs. refund and which costs less covers the timing.

Some money that passes through your terminal isn't revenue at all:

• Sales tax collected belongs to the state and stays a liability until you remit it.
• Voluntary card tips belong to staff. IRS Publication 15 counts tips paid by debit or credit card as the employee's tip income, so the business holds them and pays them out instead of booking them as sales.
• Automatic gratuities follow a different rule. IRS fact sheet FS-2015-8 says automatic gratuities are service charges, not tips, and employers who distribute them should treat them as regular wages. That generally puts the charge in revenue and the payout in payroll.
• Gift card sales are typically a liability until the card is redeemed. Our guide to setting up gift cards for a small business covers setup.
• Retainers at professional services firms usually stay unearned until the work is done.

Gross Profit Tests Your Prices

The SBA's financial statement training defines cost of goods sold (COGS) as the direct cost of producing or purchasing your product or service. For the gift shop, that's the cost of merchandise that actually left the shelf plus inbound freight: $21,600. Unsold stock stays on the balance sheet in accrual books.

Gross profit is $47,500 − $21,600 = $25,900. As a share of net sales, that's a gross margin of about 54.5% ($25,900 ÷ $47,500). If it slips from one month to the next, start with supplier invoices and your discount report, then look at shrink.

What counts as COGS depends on the business:

• Retail stores include merchandise cost, inbound freight and shrink; online sellers often add packaging and paid outbound shipping.
• Restaurants and bars track food and beverage separately. Comps and spoilage land here, so accurate counts matter.
• Salons and spas separate the cost of retail products sold from backbar supplies, such as color and wax, used during services.
• Professional services firms often have little or no COGS. Some present billable staff wages as "cost of services" so gross margin reflects project profitability.

Processing Fees Belong on Their Own Line

Operating expenses cover the cost of running the business beyond the product itself, $20,050 in the sample. Payroll is usually the biggest piece; keep wages apart from payroll taxes and benefits so you see true labor cost. A salon learns more by separating hourly staff from commissioned stylists, and booth rent from independent stylists is revenue, not payroll.

Card processing fees are a common trouble spot. Some processors deduct fees from each daily deposit, while others bill monthly. If your bookkeeper records deposits as sales, revenue is understated and the fees disappear into it. The fix is to record card sales at their gross amount and fees as a separate expense, in their own account rather than a catch-all "bank charges" line. Our walkthrough on how to record credit card processing fees in your books covers both setups.

Chargebacks need the same care. The disputed sale typically reduces revenue or goes to its own account, and any chargeback fee is an operating expense.

Running cash discount pricing, dual pricing or surcharging where permitted adds one decision: which accounts hold what customers pay toward card costs and what you pay in fees. Settle that with your bookkeeper when the program starts, and check the credit card surcharge rules before adding a surcharge.

Worked Example: What Booking Net Deposits Does to the Numbers

Assumptions, all illustrative: the gift shop's processor deducts fees from each daily deposit, all $47,000 of card sales settle within the month, and refunds are recorded on their own line as in the table above. Here is the same month recorded two ways.

Net income is identical, which is why the error can go unnoticed for years. Everything around it moves. The fee line you'd use to catch a rate increase is gone, every ratio built on net sales shifts, and the books stop tying to your processor's reports.

That last problem shows up at tax time. Form 1099-K reports the gross amount of payment transactions. If every month looked like this one, the books would show $17,400 less card revenue for the year than the processor reported (12 × $1,450). You want to explain that gap in January, not in reply to an IRS letter. Our guide to reconciling Form 1099-K before tax time shows how. Payment apps and online marketplaces follow a separate threshold. The One Big Beautiful Bill Act restored the pre-2021 rule, and IRS Fact Sheet 2025-08 confirms those platforms file only when payments exceed $20,000 and 200 transactions. That income is still taxable without a form.

Why a Profitable Month Can Leave the Bank Account Low

Operating income ($5,850) is gross profit minus operating expenses. Subtract loan interest and other non-operating items to reach net income ($5,550 before income taxes; how tax appears depends on your entity type). That profit can still end the month as a thin checking balance. The usual causes:

• Deposit timing. Card sales from the last days of the month may settle in the next one. See how long credit card deposits take.
• Inventory purchases. Cash leaves when you buy stock, but on accrual books the cost hits COGS only when items sell.
• Loan principal. Only interest is an expense. Principal payments reduce cash without touching the P&L.
• Owner draws. They come out of cash but aren't business expenses, so booking them as expenses understates profit.
• Depreciation. The SBA describes it as a way to show how tangible assets lose value over time. It reduces profit, but no cash leaves that month.

Five Ratios That Turn the P&L Into Decisions

Run these every month. Compare each one to the prior month and to the same month last year, since a gift shop's December distorts any month-to-month view.

Read gross and net margin together, because they point to different fixes. If gross margin held but net margin fell, the problem sits below the gross profit line, in labor, rent or fees. A falling gross margin calls for pricing or purchasing fixes first; trimming overhead won't rescue products priced too thin.

Restaurants and bars often combine COGS and total labor into a single prime cost ratio, since those two lines dominate their statements. Professional services firms should watch labor cost above everything else, because staff time is what they sell.

If your effective processing rate climbs while your sales mix stays the same, pull the last few processing statements. Why credit card processing fees go up explains the usual causes, and interchange-plus vs. flat-rate pricing helps you judge whether your pricing model still fits your volume.

Start With One Comparison This Week

Open last month's P&L next to your processor's monthly statement and compare the card sales figures. If the P&L number is lower by roughly your monthly fee total, your books are recording net deposits, and correcting that fixes every ratio above.

When the real fee line turns out higher than you expected, MannyPay works with retail stores, restaurants and bars and salons and spas, with cost programs that include cash discount, dual pricing and surcharging where permitted. Request a free quote and a MannyPay specialist will respond within one business day.

Sources

1. U.S. Small Business Administration, Preparing Financial Statements
2. U.S. Small Business Administration (SBA Ascent), How to Understand a Profit and Loss Statement
3. IRS Publication 538, Accounting Periods and Methods
4. IRS, Treasury Decision 9942, Small Business Taxpayer Exceptions Under Sections 263A, 448, 460 and 471
5. IRS Publication 15 (2026), Circular E, Employer's Tax Guide
6. Tax Notes, Fact Sheet Explains How to Report Tips and Service Charges (IRS FS-2015-8)
7. Baker Tilly, 2025 Accounting Method Changes for Taxpayers
8. 1-800Accountant, Schedule C Accounting Methods: Cash vs Accrual for 2025
9. CPA Practice Advisor, IRS Issues New FAQs on $20,000 Form 1099-K Threshold Under OBBBA

IC

About the author

Isabella Cruz

Isabella Cruz is Business Growth & Commerce Editor for Beyond the Swipe, writing for small businesses, restaurants, retailers, entertainment venues and e-commerce sellers.

This article is for general educational purposes and is not legal, tax or financial advice. Card network rules and state laws change; confirm current requirements for your business.