FINANCIAL STATEMENTS
These are prepared at the end of a given trading period to determine the profit and losses of the business and to show the financial position of the business at a given time.
They include the trading account, profit and loss account, trading profit and loss account, and the balance sheet.
They are also referred to as the final statements.
The trading period is the duration through which the trading activities are carried out in the business before it decides to determine its performance in terms of profit or loss. It may be one week, month, six months, or even a year depending on what the owner wants.
Most businesses use one year as their trading period. It is also referred to as the accounting period.
At the end of the accounting period, the following takes place:
- All the accounts are balanced off
- A trial balance is extracted
- Profit or loss is determined
- The balance sheet is prepared
Determining the profit or loss of a business
When a business sells its stock above the buying price/cost of acquiring the stock, it makes a profit, while if it sells below, it makes a loss. The profit realized when the business sells its stock beyond the cost is referred to as the gross profit, while if it is a loss, it is referred to as a gross loss.
It is called gross profit/loss because it has not been used to cater for the expenses that may have been incurred in selling that stock, such as the salary of the salesman, rent for the premises, water bills, etc. This implies that the businessman cannot take the whole gross profit for personal use but must first deduct the total cost of all other expenses that may have been incurred.
The profit realized after the cost of all the expenses incurred has been deducted is the real profit for the owner of the business and is referred to as Net profit. The net profit can be determined through calculation or preparation of the profit and loss account.
In calculating the gross profit, the following adjustments are made:
- Return inwards/Sales return: These are goods that had been sold to customers but were returned to the business for one reason or another. It reduces the value of sales and is subtracted from sales to obtain the net sales.
Therefore Net sales = Sales – Return inwards - Return outwards/Purchases return: These are goods that had been bought from suppliers and returned to them for one reason or another. It reduces the purchases and is subtracted from the purchases to obtain the net purchases.
- Drawings: This refers to goods that the owner of the business has taken from the business for personal use. It reduces the value of purchases and is subtracted from purchases when determining the net purchases. It differs from other drawings in that it is purely goods and not money.
- Carriage inwards/Carriage on purchases: This is the cost incurred by the suppliers in transporting the goods from their premises to the customer’s business. It is treated as part of the purchases and therefore increases the value of purchases. It is added to purchases to determine the actual value of purchases/Net purchases.
Therefore Net Purchases = Purchases + Carriage inwards – Return Outwards – Drawings - Carriage outwards/Carriage on sales: This is the cost that the business has incurred in transporting goods from its premises to the customer’s premises. The cost reduces the business profit that would have been realized as a result of the sale and is therefore treated as an expense and is subtracted from the gross profit before determining the net profit.
- Opening stock is the stock of goods at the beginning of the trading period, while the closing stock is the stock of goods at the end of the trading period.
Gross profit is therefore calculated as follows:
Gross Profit = Sales – Return inwards – (Opening stock + Purchases + Carriage inwards – Return outwards – Closing stock)
Or
Gross profit = Net sales – Cost of Goods Sold (COGS)
COGS = Opening Stock + Net Purchases – Closing stock
Net Profit = Gross profit – Total expenses
Trading Account
This is prepared by the business to determine the gross profit/loss during that trading period.
It takes the following format:
Name of the business
Trading Account
Dr For the period (date) Cr
Shs Shs Opening stock xxxxxx add Purchases xxxxx add Carriage inwards xxx less Return Outwards xxx less Drawings xxxxx Goods available for sale xxxxxx Less Closing Stock xxx Cost Of Goods Sold (COGS) xxxxxx Gross profit c/d xxxx xxxxxx | Shs Shs Sales xxxxxx Less Return inwards xxx Net sales xxxxxx xxxxxx Gross profit b/d xxxx |
The trading account is completed when the gross profit b/d is determined.
For example:
The following balances were obtained from the books of Ramera Traders for the year ending May 31st, 2010:
- Sales 670,000
- Purchases 380,000
- Return inwards 40,000
- Carriage outwards 18,000
- Return outwards 20,000
- Carriage inwards 10,000
Additional information:
- During the year the owner took goods worth sh 5,000 for his family use.
- The stock as at 1st June 2009 was shs 60,000, while the stock as at 31st May 2011 was shs 70,000.
Required: Prepare Ramera Traders trading account for the period ending 31st May 2010.
Ramera Traders
Trading Account
Dr For the period ending 31/5/2010 Cr
Shs Shs Opening stock 60,000 add Purchases 380,000 add Carriage inwards 10,000 less Return Outwards 20,000 less Drawings 5,000 365,000 Goods available for sale 425,000 Less Closing Stock 70,000 Cost Of Goods Sold (COGS) 355,000 Gross profit c/d 275,000 630,000 | Shs Shs Sales 670,000 Less Return inwards 40,000 Net sales 630,000 630,000 Gross profit b/d 275,000 |
NB: Carriage outwards is not an item of the Trading account but of the profit and loss account as an expense.
Importance of Trading account
- It is used to determine the gross profit/loss for a given trading period for appropriate decision making by the management.
- It is used in determining the cost of goods that were sold during that particular accounting period.
- It is used to reveal the volume of turnover, i.e., net sales.
- It may be used to compare the performance of the business in the current accounting period and previous periods. It can also compare its performance with other similar businesses.
- It facilitates the preparation of the profit and loss account, since the gross profit is carried forward to the profit and loss account.
Profit and Loss account
In preparation of this account, the gross profit is brought down on the credit side, with all other revenues/income of the business being credited and the expenses together with the net profit being debited. Net profit = Total Revenues (including Gross Profit) – Total expenses
Name of the business
Profit and Loss Account
Dr For the period (date) Cr
Shs Expenses Insurance xxx Electricity xxx Water bills xxx Carriage Outwards xxx General expenses xxx Provision for Depreciation xxxx Discount allowed xxx Commission allowed xxxx Rent paid xxxx Any other expense xxxx Net profit c/d xxxx xxxxxx | Shs Gross profit b/d xxxxxx Discount received xxx Rent income xxx Commission received xxx Any other income received xxx xxxxxx Net profit b/d xxxx |
The Profit and Loss Account is complete when net profit b/d is obtained. In the trial balance, the revenues/incomes are always credited, while the expenses are debited, and the same treatment is found in the Profit and Loss Account. (Any item that is taken to the Profit and Loss Account with a balance appearing in the Debit (Dr) side of a trial balance is treated as an expense, while those appearing in the Credit (Cr) side are revenue e.g., discount balance appearing in the Dr Side is Discount Allowed, while the one on Cr side is Discount Received.)
For example
The following information relates to Akinyi’s Traders for the period ending March 28th, 2010. Use it to prepare the profit and loss account.
Gross profit 100,000 Discount received 12,000
Salaries and wages 20,000 Power and lighting 10,000
Opening stock 150,000 Rent income 10,000
Commission allowed 15,000 Commission received 16,000
Repairs 10,000 Discount allowed 8,000
Provision for depreciation 6,000 Carriage outwards 4,000
Akinyi Traders
Profit and Loss Account
Dr For the period ending 28th March 2010 Cr
Shs Expenses Power and lighting 10,000 Carriage Outwards 4,000 Salaries and wages 20,000 Provision for Depreciation 6,000 Discount allowed 8,000 Commission allowed 15,000 Repairs 10,000 Net profit c/d 65,000 138,000 | Shs Gross profit b/d 100,000 Discount received 12,000 Rent income 10,000 Commission received 16,000 138,000 Net profit b/d 65,000 |
If the expenses are more than the income, then the business shall have made a net loss, and the loss will be credited.
Net profit/loss can also be found through calculation as follows:
Net profit/loss = Gross profit + Total other revenues – Total expenses
For the above example:
Total other revenues = 12,000 + 10,000 + 16,000 = 38,000
Total expenses = 10,000 + 4,000 + 20,000 + 6,000 + 8,000 + 15,000 + 10,000 = 73,000
Therefore; Net profit = Gross profit + Total other revenues – Total expenses = 100,000 + 38,000 – 73,000 = 65,000
Importance of Profit and Loss account
- It shows the revenue earned and all the expenses incurred during the accounting period.
- It is used to determine the net profit/net loss of a given trading period.
- It is a requirement by the government for the purpose of taxation.
- It may be used by employees to gauge the strength of the business in terms of its ability to pay them well.
- It is vital for prospective investors in the business to determine the viability of the business.
- Creditors or lenders may use it to assess the business’s ability to pay back their debts.
- It is used by management to make decisions on the future of their business.
Trading, Profit and Loss Account
This is the combination of the trading account and profit and loss account to form a single document. It ends when the net profit/loss brought down has been determined. That is:
Name of the business
Trading, Profit and Loss Account
Dr For the period (date) Cr
Shs Shs Opening stock xxxxxx add Purchases xxxxx add Carriage inwards xxx less Return Outwards xxx less Drawings xxxxx Goods available for sale xxxxxx Less Closing Stock xxx Cost Of Goods Sold (COGS) xxxxxx Gross profit c/d xxxx xxxxxx Expenses Insurance xxx Electricity xxx Water bills xxx Carriage Outwards xxx General expenses xxx Provision for Depreciation xxxx Discount allowed xxx Commission allowed xxxx Rent paid xxxx Any other expense xxxx Net profit c/d xxxx xxxxxx | Shs Shs Sales xxxxxx Less Return inwards xxx Net sales xxxxxx xxxxxx Gross profit b/d xxxx Discount received xxx Rent income xxx Commission received xxx Any other income received xxx xxxxxx Net profit b/d xxxx |
End Year Adjustments
The following items may require adjustment at the end of the trading period:
- Revenues/Income
- Expenses
- Fixed assets
Adjustment on revenues
The revenue may have been paid in advance in part or whole (prepaid revenue) or may be paid later after the trading period (accrued revenue).
Prepaid revenue is subtracted from the revenue/income to be received, and the difference is what is treated in the profit and loss account or trading profit and loss account as income, while the accrued revenue is added to the revenue/income to be received and the sum is what is treated in the above accounts as the actual revenue.
Only the prepaid amount and the accrued amounts are then taken to the balance sheet.
Adjustment on the expenses
The expenses may have been paid for in advance in part or whole (prepaid expenses) or may be paid for later after the trading period (accrued expenses).
Prepaid expenses are subtracted from the expenses to be paid for, and the difference is what is treated in the profit and loss account or trading profit and loss account as an expense, while the accrued expenses are added to the expenses to be paid for and the sum is what is treated in the above accounts as the actual expenses.
NB: Only the prepaid amount and the accrued amounts are then taken to the balance sheet.
Adjustment on fixed assets
The fixed assets may decrease in value due to wear and tear. This makes the value go down over time, which is referred to as depreciation. The amount of depreciation is always estimated as a percentage of cost.
The amount that has depreciated is treated in the profit and loss account or T,P&L as an expense, while the value of the asset is recorded in the balance sheet, less depreciation.
For example;
- 1997 The following Trial balance was prepared from the books of Paka Traders as at 31st December 1995. Trial balance December 31st 1995
Dr. (shs) Cr. (shs)
Sales 980,000
Purchases 600,000
Returns 80,000 20,000
Carriage in 40,000
Carriage out 3,000
Stock (Jan 1st 1999) 120,000
Rent 60,000 45,000
Discount 15,000 25,000
Motor vehicle 150,000
Machinery 250,000
Debtors 120,000
Salaries 18,000
Commission 7,000 12,000
Capital 178,000
Insurance 15,000
Creditors 240,000
Cash 122,000
1,540,000 1,540,000
Additional information
- Stock as at 31st December was 100,000
- The provision for depreciation was 10% on the cost of Motor vehicle, and 5% on the cost of Machinery
Required: Prepare trading profit and loss account for the period ending 31st December 1999.
Adjustments: Provision for depreciation;
Machinery = 7,500
(New balance of machinery = 250,000 – 7,500 = 242,500. The 242,500 is taken to the balance as Machinery (fixed asset), while 7,500 is taken to the trading profit and loss account as expenses)
Motor vehicle = 15,000
(New balance of Motor Vehicle = 150,000 – 15,000 = 135,000. The 135,000 is taken to the balance as Motor Vehicle (fixed asset), while 15,000 is taken to the trading profit and loss account as expenses)
Paka Traders
Trading, Profit and Loss Account
Dr For the period 31/12/1995 Cr
Shs Shs Opening stock 120,000 add Purchases 600,000 add Carriage inwards 40,000 less Return Outwards 20,000 620,000 Goods available for sale 740,000 Less Closing Stock 100,000 Cost Of Goods Sold (COGS) 640,000 Gross profit c/d 260,000 900,000 Expenses Insurance 15,000 Carriage Outwards 30,000 Salaries 18,000 Provision for Depreciation Motor vehicle 15,000 Machinery 7,500 22,500 Discount allowed 15,000 Commission allowed 7,000 Rent paid 60,000 Net profit c/d 174,500 342,000 | Shs Shs Sales 980,000 Less Return inwards 80,000 Net sales 900,000 900,000 Gross profit b/d 260,000 Discount received 25,000 Rent income 45,000 Commission received 12,000 342,000 Net profit b/d 174,500 |
The net profit/loss may be taken to the balance sheet.
The items that have been adjusted will be recorded in the balance sheet less the adjustment.
The Balance Sheet
The balance sheet shows the business’s financial position in relation to assets, capital, and liabilities. The adjustments that can be made will be on fixed assets and capital only. That is:
Fixed assets are recorded less their depreciation value (should there be provision for depreciation) as the actual value.
Actual value of assets = Old value – depreciation.
Capital is adjusted with the following: Net capital, Drawings, and additional investment. i.e.
Closing Capital/Net capital (C.C) = Opening/initial capital (O.C) + Additional Investment (I) + Net profit (N.P) or (less Net Loss) – Drawings
CC = OC + I + NP – D
Where:
Opening Capital: the capital at the beginning of the trading period
Closing capital: the capital as at the end of the trading period
Additional Investment: any amount or asset that the owner adds to the business during the trading period
Net profit: the profit obtained from the trading activities during the period. In case of a loss, it is subtracted.
Types of Capital
The capital in the business can be classified as follows:
- Capital Owned/Owner’s Equity/Capital invested: this is the capital that the owner of the business has contributed to the business. It is the Net capital/Closing capital of the business (C = A – L)
- Borrowed capital: the resources brought into the business from outside sources. They are the long-term liabilities of the business.
- Working capital: these are resources in the business that can be used to meet the immediate obligations of the business. It is the difference between the total current assets and total current liabilities.
Working Capital = Total Current Assets – Total Current Liabilities - Capital employed: these are the resources that have been put in the business for the long term. i.e.
Capital Employed = Total Fixed assets + Working Capital
Or
Capital employed = Capital Invested + Long term liabilities
Name of the business
Balance Sheet
As at (date)
Shs shs Fixed Assets Land xxxxx Buildings xxxxx Motor Vehicle xxxxx Any other fixed assets xxxxx xxxxxx Current Assets Stock xxxx Debtors xxxx Bank xxxx Cash xxxx Prepaid Expenses xxxx Accrued revenues xxxx Any other current assets xxxx xxxxxx xxxxxx | Shs shs Capital xxxxx Add Net profit xxxx Add additional investt xxx Less drawings xxx Net Capital xxxxx Long term liabilities Long term loan xxxx Any other xxxx xxxx Current liabilities Creditors xxxx Short term loan xxxx Accrued expenses xxxx Prepaid revenues xxxx Any other xxxx xxxxx xxxxxx |
Example 00A: The following information was extracted from the trial balance of Mwema traders on 31st December 2010:
Sales 750,000 Furniture 288,000
Purchases 540,000 Electricity expenses 16,000
Sales return 24,000 Motor vehicle 720,000
Return outwards 30,000 Rent expenses 2,500
General expenses 72,000 Capital 842,500
Commission received 24,000 Bank Loan 250,000
Cash 156,000 Creditors 216,000
Debtors 244,000
Additional Information
- Stock as at 31/12/2010 was ksh 72,000
- Electricity prepaid was shs 4,000
- Rent expenses accrued shs 3,500
- Depreciation was provided for as follows:
– Motor Vehicle 15% p.a. on cost – Furniture 6% p.a. on cost
Required
- Prepare Trading, profit and loss account for the year
- Prepare a balance sheet as at 31st December 2012
- Determine the following:
– Owner’s equity – Borrowed capital – Working capital – Capital employed
Adjustments:
Motor Vehicle = 108,000
Therefore Motor vehicle = 612,000
Furniture = 17,280
Therefore furniture = 270,720
Mwema Traders
Trading, Profit and Loss Account
Dr For the period 31/12/2010 Cr
Shs Shs Purchases 540,000 less Return Outwards 30,000 510,000 Goods available for sale 510,000 Less Closing Stock 72,000 Cost Of Goods Sold (COGS) 438,000 Gross profit c/d 288,000 726,000 Expenses General expenses 72,000 Electricity expenses 16,000 Less Electricity prepaid 4,000 12,000 Rent expenses 2,500 Accrued rent exp 3,500 6,000 Provision for Depreciation Motor vehicle 108,000 Furniture 17,280 125,280 Net profit c/d 96,720 312,000 | Shs Shs Sales 750,000 Less Return inwards 24,000 Net sales 726,000 726,000 Gross profit b/d 288,000 Commission received 24,000 312,000 Net profit b/d 96,720 |
Mwema Traders
Balance Sheet
As at 31/12/2010
Shs shs Fixed Assets Motor Vehicle 612,000 Furniture 270,720 882,720 Current Assets Stock 72,000 Debtors 244,000 Electricity prepaid 4,000 Bank 50,000 Cash 156,000 526,000 1,408,720 | Shs shs Capital 842,500 Add Net profit 96,720 Net Capital 939,220 Long term liabilities Bank Loan 250,000 Current liabilities Creditors 216,000 Accrued rent 3,500 219,500 1,408,720 |
Basic Financial Ratios
A ratio is an expression of one item in relation to another. It is used to compare groups of related items in the business for the purpose of assessing the performance of the business. They include:
- Mark-up
This is the comparison of gross profit as a percentage of cost of goods sold. i.e.
Mark-up = (Gross Profit / Cost of Goods Sold) × 100
For example: in (example 00A) above, determine the mark-up of the business.
Mark-up = (288,000 / 438,000) × 100 = 65.75%
(This implies that the Gross profit of the business is 65.75% of its cost of goods sold.)
- Margin
This is the expression of the gross profit as a percentage of net sales. That is:
Margin = (Gross Profit / Net Sales) × 100
For example: in (example 00A) above, determine the margin of the business.
Margin = (288,000 / 726,000) × 100 = 39.67%
(This implies that the gross profit of the business is 39.67% of the net sales.)
Relationship between margin and mark-up
Since margin and mark-up are both expressions of Gross profit, it is possible to convert one to the other.
- Changing mark-up to margin
Mark-up can be changed to margin as follows:
- Convert the mark-up percentage to a fraction in its simplest form.
- Add the value of the numerator of the fraction to the denominator to come up with the new fraction (margin fraction) that is:
If the mark-up fraction = a/b,
Margin fraction = a / (a + b)
- Convert the margin fraction to a percentage to obtain margin.
For example: in the above example,
Mark-up = 65.75% = 65.75/100 = 263/400 (approximate fraction)
Margin fraction = 263 / (263 + 400) = 263 / 663 × 100 = 39.67%
- Changing margin to mark-up
- Convert the margin percentage to a fraction in its simplest form.
- Subtract the value of the numerator of the fraction from the denominator to come up with the new fraction (mark-up fraction) that is:
If the margin fraction = a/b,
Mark-up fraction = a / (b – a)
- Convert the mark-up fraction to a percentage to obtain mark-up.
For example: in the above example,
Margin = 39.67% = 39.67/100 = 263/663 (approximate fraction)
Mark-up fraction = 263 / (663 – 263) = 263 / 400 × 100 = 65.75%
- Current ratio/working capital ratio
This is the ratio of the current assets to current liabilities. It can also be expressed as a percentage. That is:
Current ratio = Current assets / Current liabilities
Or
Current ratio = (Current assets / Current liabilities) × 100
For example: in (example 00A) above, determine the current ratio;
Current assets = 526,000
Current liabilities = 219,500
Current ratio = 526,000 / 219,500 = 2.4 : 1
Or
= (526,000 / 219,500) × 100 = 239.64%
- Rate of stock turnover
This is the rate at which the stock is bought or sold within a given period of time. It is obtained by:
Rate of stock turnover (ROST) = Cost of Goods Sold / Average stock
Average stock = (Opening stock + Closing stock) / 2
In (example 00A) above, determine the rate of stock turnover;
The cost of goods sold = 438,000
The closing stock = 72,000
The opening stock = 0
Therefore
The average stock = (0 + 72,000) / 2 = 36,000
Rate of stock turnover (ROST) = 438,000 / 36,000 = 12.17 Times
- Return on capital
This is the expression of net profit as a percentage of the capital invested. That is:
Return on capital = (Net Profit / Capital invested) × 100
It can be given as a ratio or a percentage.
For example: in (example 00A) above, determine the return on capital of the business.
Net Profit = 96,720
Capital invested/owner’s equity = 939,220
Return on capital = (96,720 / 939,220) × 100 = 10.33%
- Acid test ratio/quick ratio
This shows how fast the business can convert its current assets excluding stock to settle its current liabilities. That is:
Quick ratio = (Current assets – Stock) / Current liabilities
It is given in ratio form.
For example: in above (example 00A), determine the quick ratio;
Current assets = 526,000
Stock = 72,000
Current liabilities = 219,500
Quick ratio = (526,000 – 72,000) / 219,500 = 454,000 / 219,500 = 2.07 (or 207 : 100)
Importance of Financial Ratios
- Mark-up and margin help in the following: setting the selling price, calculating profit or losses, and determining the sales for a given period of time.
- Working capital and acid test ratio help in showing whether the business is in a position to meet its short-term obligations and checking whether the business is utilizing its resources properly. That is, a high working capital ratio shows that most of the resources are idle.
- Return on capital shows the following:
- The performance of the business in relation to other similar businesses.
- Comparison of the performance of the business over different periods.
- Whether the business finances have been invested or not.
- Helps potential investors in deciding where to invest.
- Rate of stock turnover also helps in determining how fast or slow the stock is moving. It also helps in computing the gross profit or loss.
