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Financial Statements

These are prepared at the end of a given trading period to determine the profit and losses of the business, and also to show the financial position of the business at a given time.
They includes; 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 determines it performances 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 of the business 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 sell it stock beyond the cost is what is referred to as the gross profit, while if it is a loss then it is referred to as a gross loss.

It is referred to as the 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. it therefore implies that the businessman cannot take the whole gross profit for its 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 what becomes 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 profit and loss account.

In calculating the gross profit, the following adjustments are put in place;

Return inwards/Sales return: - these are goods that had been sold to the customers, but they have returned them to the business for one reason or the other. It therefore reduces the value of sales, and is therefore 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 the suppliers to the business and have been returned to them for one reason or the other. It reduces the purchases and is therefore 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 his own use. It reduces the value of purchases, and is therefore subtracted from purchases when determining the net purchases. It is different from the other drawing 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 his premises to the customers 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 the 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)
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:

Trading Account - Business Studies Form Four

The trading account is completed by the time 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.

Trading Account - Business Studies Form Four

NB: Carriage outwards is not an item of Trading account, but 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 was sold during that particular accounting period.
It is used to reveal the volume of turnover i.e net sales.
May be used to compare the performance of the business in the current accounting period and the previous periods. It can also compare its performance with other similar businesses.
Facilitates the preparation of 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 sides, 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

Profit and Loss Account - Business Studies Form Four

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 profit and loss account.

Gross profit → 100 000
Salaries and wages → 20 000
Opening stock → 150 000
Rent income → 10 000
Discount received → 12 000
Commission allowed → 15 000

Repairs → 10 000
Discount allowed → 8 000
Commission received → 16 000
Carriage outwards → 4 000
Provision for depreciation → 6 000
Power and lighting → 10 000

Profit and Loss Account - Business Studies Form Four

In case 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 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.
May be used by the employees to gauge the strength of the business, in terms of its ability to pay them well.
It is vital for the prospective investor in the business, in terms of determining the viability of the business.
The creditors or loaners may use it to assess the business ability to pay back their debts.
It is used by the management to make a decision on the future of their business.

Trading, Profit and Loss Account

This is the combination of trading account and trading profit and loss account to form a single document.
It ends when the net profit/loss brought down has been determined.

Profit and Loss Account - Business Studies Form Four

End Year Adjustments
The following items may require to be adjusted 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 an 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 what 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 is 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 is added to the expenses to be paid for and the sum is what is treated in the above accounts as the actual expenses.
NOTE:
Only the prepaid amount and the accrued amounts are what are then taken to the balance sheet.
Adjustment on fixed assets
- The fixed assets may decrease in value, due to tear and wear. This makes the value to go down over time, what is referred to as depreciation. The amount of depreciation is always estimated as a percentage of cost.
- The amount that shall have 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 - Business Studies Form Four

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)

Trading, Priofit and Loss Account - Business Studies Form Four

- 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 will show the business financial position in relation to assets, capital and liabilities. The adjustment that can be made will be on Fixed assets and capital only.
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 the 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 obligation 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 has been put in the business for a 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)
Balance Sheet - Business Studies Form Four

Example 00A: The following information were extracted from the trial balance of Mwema traders on 31st December 2010

Sales → 750 000
Purchases → 540 000
Sales return → 24 000
Return outwards → 30 000
General expenses → 72 000
Commission received → 24 000
Cash → 156 000
Debtors → 244 000

Furniture → 288 000
Electricity expenses → 16 000
Motor vehicle → 720 000
Rent expenses → 2 500
Capital → 842 500
Bank Loan → 250 000
Creditors → 216 000

Additional Information
- Stock as at 31/12/2010 was ksh 72 000
- Electricity prepaid was shs 4 000
- Rent expenses accrued shs 3500
- 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

Profit and Loss Account - Business Studies Form Four

Balance Sheet - Business Studies Form Four

Basic Financial Ratios

- A ratio is an expression of one item in relation to the other. It is used to compare the groups of related items in the business, for the purpose of assessing the performance of the business. They include:

a) Mark-up

This is the comparison of gross profit as a percentage of cost of goods sold. i.e.

Mark-up - Business Studies Form Four

b) Margin

This is the expression of the gross profit as a percentage of net sales. That is:

Margin - Business Studies Form Four

Relationship between margin and mark-up
- Since margin and mark-up are all the expression of Gross profit, it is possible to change one to the other.
Changing mark-up to margin
- Mark-up can be changed to margin as follows:
- Convert the mark-up percentage as 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 = Margin fraction
- Convert the margin fraction as a percentage to obtain margin.
Changing margin to mark-up
- Convert the margin percentage as 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 = Mark-up fraction
- Convert the mark-up fraction as a percentage to obtain mark-up

c) 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

Current ratio - Business Studies Form Four

d) 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 - Business Studies Form Four

e) Return on capital

This is the expression of net profit as a percentage of the capital invested. That is;

Return on capital - Business Studies Form Four

f) 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;

Return on capital - Business Studies Form Four

Importance of Financial Ratios

Mark up and margin helps 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 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
- Help the potential investors on the decision on where to invest
Rate of stock turnover also help in determining how fast or slow the stock is moving. It also helps in computing the gross profit or loss.

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Financial Statements - Form 4 Business Studies

Financial Statements

Guest Account

Feeling Ready?

Financial Statements

Determining the profit or loss of a business

Trading Account

Importance of Trading account

Profit and Loss account

Trading, Profit and Loss Account

The Balance Sheet

Basic Financial Ratios

a) Mark-up

b) Margin

c) Current ratio/working capital ratio

d) Rate of stock turnover

e) Return on capital

f) Acid test ratio/quick ratio

Importance of Financial Ratios

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