Business Finance Guide · Accounting
Read your P&L and balance sheet like a lender
What each report shows, how they connect and the numbers banks check first.
A profit and loss statement shows whether your business made money over a period; a balance sheet shows what it owns and owes on a single day.
Together, these two reports answer the questions every lender, investor and buyer asks first: Is this business profitable? Can it pay its debts? Is it getting stronger or weaker? You do not need to be an accountant to read them, but you do need to know what each line means. The U.S. Securities and Exchange Commission (SEC) calls financial statements the starting point for judging any company’s health.
The stakes are real. In the Federal Reserve’s 2025 Small Business Credit Survey, firms denied financing most often cited strict lender requirements, followed by too much existing debt (37%), a low credit score (30%), and weak sales or insufficient collateral (29% each). Most of those reasons show up on the P&L and the balance sheet before a lender ever sees them.
Why applicants were denied financing (2025)
Share of applicants not approved for at least some financing; more than one reason allowed. Source: Federal Reserve Banks, 2026 Report on Employer Firms.
The profit and loss statement (P&L)
The P&L, also called the income statement, covers a period such as a month, quarter or year. It starts with revenue at the top and subtracts costs in layers until it reaches net income, the famous “bottom line.” Each layer tells you something different:
- Revenue: sales of goods and services, before any costs.
- Cost of goods sold (COGS): the direct cost of what you sold, such as ingredients, inventory or job materials.
- Gross profit: revenue minus COGS. It shows whether your pricing covers your direct costs.
- Operating expenses: payroll, rent, utilities, marketing, software and insurance.
- Operating income: gross profit minus operating expenses, the profit from running the business.
- Net income: what is left after interest and taxes.
Example P&L: a Sacramento coffee shop, one year
Illustrative example with round numbers, not a real business.
In the example, the shop keeps $54,000 of every $600,000 in sales, a 9% net margin. The waterfall makes the big levers obvious: food and drink costs take almost a third of revenue, and payroll takes another 35%. A 2% change in either one moves the bottom line more than most marketing campaigns.
The balance sheet
The balance sheet is a snapshot on one date, usually the last day of a month or year. It lists what the business owns (assets), what it owes (liabilities) and what is left for the owners (equity). It always follows one rule, the accounting equation:
The accounting equation, using the coffee shop example
Illustrative example. Assets always equal liabilities plus equity.
- Current assets: cash, accounts receivable and inventory that will turn into cash within a year.
- Fixed assets: equipment, vehicles, furniture and buildings, minus accumulated depreciation.
- Current liabilities: bills, credit card balances and loan payments due within a year.
- Long-term liabilities: loan balances due after one year.
- Equity: money the owners put in plus profits kept in the business, minus owner draws.
How the two reports connect
The reports are linked. Net income from the P&L flows into equity on the balance sheet, as retained earnings, unless the owners take it out. If the coffee shop earns $54,000 and the owner draws $30,000, equity grows by $24,000. The third report, the cash flow statement, explains why a profitable business can still run short of cash; see our guide to the cash flow statement.
The three financial statements
| Profit and loss | Balance sheet | Cash flow statement | |
|---|---|---|---|
| Answers | Did we make money? | What do we own and owe? | Where did the cash go? |
| Time frame | A period (month, quarter, year) | A single date | A period |
| Key line | Net income | Equity | Ending cash |
| Lenders use it to judge | Profitability and repayment ability | Leverage and collateral | Liquidity |
Five ratios lenders check first
Debt service coverage compares the cash a business generates with its yearly loan payments. A ratio of 1.25 means $1.25 of cash for every $1.00 of debt payments; many banks look for at least that. The current ratio (current assets divided by current liabilities) shows whether you can pay bills due this year; above 1.0 is the minimum, and many lenders prefer 1.2 or more.
How to keep both reports accurate
Monthly close checklist
- Separate the moneyRun everything through a business bank account and business cards.
- Use accounting softwareConnect bank feeds so transactions import automatically.
- Categorize every transactionMatch each one to the right account: COGS, payroll, rent and so on.
- Reconcile monthlyMake sure the software balance matches every bank and card statement.
- Review the reportsCompare this month’s P&L with last month and last year; check the balance sheet for growing payables or shrinking cash.
- Keep the recordsThe IRS generally expects records that support income and deductions for at least three years.
Reading trends, not just totals
A single P&L tells you little. The value is in comparison. Put this month next to the same month last year to remove seasonal effects, and track margins as percentages so growth does not hide problems. Revenue up 15% with gross margin down from 67% to 62% may mean rising supplier prices or too many discounts, and it can erase the benefit of the extra sales.
On the balance sheet, watch the direction of a few lines each month: cash, accounts receivable, inventory, accounts payable and total debt. Receivables growing faster than sales means customers are paying more slowly. Payables growing faster than sales may mean you are stretching suppliers to cover a cash gap. Either one deserves a closer look.
Common mistakes
- Treating owner draws as expenses. Draws reduce equity on the balance sheet; they are not operating costs on the P&L of an LLC or sole proprietorship.
- Expensing equipment. Large purchases usually belong on the balance sheet and are depreciated over time, even if taxes allow a faster write-off.
- Recording loan payments as expenses. Only the interest is an expense; principal reduces the loan balance.
- Waiting until tax time. Annual statements arrive too late to fix the problems they reveal.
Key terms
- Accrual accounting: records revenue when earned and expenses when incurred, regardless of when cash moves.
- Cash-basis accounting: records revenue and expenses when cash is received or paid.
- Accounts receivable: money customers owe you for sales already made.
- Accounts payable: money you owe suppliers for goods and services already received.
- Retained earnings: cumulative profits kept in the business rather than paid to owners.
- Depreciation: spreading the cost of a long-lived asset over its useful life.
The bottom line: the P&L tells you whether the business is earning money, and the balance sheet tells you whether it is financially sound. Review both every month, compare them with last year and you will spot problems, and opportunities, long before a lender or the IRS does.
Free help in the Sacramento region
You do not have to work through these decisions alone. SCORE Sacramento pairs owners with volunteer mentors, many of them retired executives, bankers and accountants, at no cost. The Sacramento Valley Small Business Development Center offers free one-on-one advising on financing, budgeting and financial statements. The SBA’s Sacramento District Office can explain loan programs and connect you with lenders, and community lenders such as California Capital and Opening Doors serve owners who need smaller loans or extra support. Browse our Business Resources and the free business help guide for more.
Key takeaways
- The P&L shows profit over a period; the balance sheet shows assets, liabilities and equity on one day.
- Assets always equal liabilities plus equity.
- Net income flows into equity on the balance sheet unless the owners draw it out.
- Too much debt (37%), weak sales (29%) and thin collateral (29%) were common reasons for denial in 2025, and all show up in these reports.
- Close your books monthly so the statements are ready when a lender asks.
Frequently asked questions
What is the difference between a P&L and a balance sheet?
A profit and loss statement shows revenue, costs and profit over a period of time. A balance sheet shows what the business owns, owes and the owners’ equity on a single date.
Which financial statements do lenders ask for?
Most lenders ask for profit and loss statements and balance sheets, often for the last two or three years plus the current year to date, along with business tax returns.
Can a profitable business run out of cash?
Yes. Profit counts sales when they are made, but cash arrives when customers pay. Inventory purchases, loan principal and slow-paying customers can drain cash even in a profitable year.
How often should I review my financial statements?
Monthly. A monthly close catches mistakes early and shows trends in time to act.
Do I need an accountant to prepare a P&L?
Accounting software can produce both statements if your transactions are categorized correctly. A bookkeeper or CPA is worth it for payroll, taxes and statements prepared for a loan application.
Sources
- U.S. Securities and Exchange Commission: Beginners’ guide to financial statements
- SBA: Manage your finances
- Federal Reserve Banks: 2026 Report on Employer Firms (2025 Small Business Credit Survey)
- IRS: Recordkeeping for small businesses
Keep reading on Inksight
- Business Credit vs. Personal Credit: What Every Small Business Owner Should Know
- How to Choose a Business Structure in California: Sole Proprietorship, LLC, S Corp or C Corp
- Business Banking 101: How to Choose and Open a Business Bank Account
- Small Business Funding Options: Loans, Grants and Investors
- Business Resources: all guides →
