TOPIC: INCOME STATEMENTS

Lesson Objectives: At the end of the lesson, students should be able to explain:

 what profit is and why it is important

 how a profit is made
 importance of profit to private sector businesses, e.g. reward for risk taking/enterprise,
source of finance
 difference between profit and cash
 main features of an income statement, e.g. revenue, cost of sales, gross profit, profit
retained profit and balance sheet

Accounts are the financial records of a firm’s transactions.

Final Accounts are prepared at the end of the financial year and give details of the profit or loss
made as well as the worth of the business.

What is Profit?
Profit (Net Profit): is the difference between revenue and total costs or the difference between
the revenue from sales and total costs or the difference between gross profit and expenses.

There are three types of Profits:-

Gross Profit: the difference between the revenue earned from selling products and the cost of
making those products
Profit: as defined above.
Retained profit: the owners of a profitable business may decide to reinvest some of the profits in
the business.
When the total costs exceed the sales revenue, then a loss is made.

How is profit made?

A business earns a profit by selling its products to customers at a price which is higher than the
total costs of making and supplying those products
Profit = Sales Revenue (TR) – Total costs (TC)
Revenue (Sales): is the money earned from the sale of products.
TC = Selling price (sp) x quantity sold (q)
Cost of Sales: the costs of purchasing the goods used to make the products sold.

How to increase profit

 Increase sales revenue
  Cut costs
 Selling more products
 Increasing the price
 No discounting
 Find cheaper suppliers.

Why is profit important to a business?

 It is a reward for enterprise: entrepreneurs start businesses to make a profit.

 It is a reward for risk-taking: entrepreneurs have to take considerable risks when they invest
capital in a venture, and profits are a compensation/reward to them for taking these risks
(paid in the form of profits or dividends).
 It is a source of finance: after payments to owners, profits are reinvested back into the
business for further expansion (this is called retained earnings).
 It is an indicator of success: more profits indicate to investors that the business/industry is
worth their time and money, and they will invest more either in the firm or new firms of
their own, in the hopes of gaining good returns on their investment

For social enterprises, profit is not one of their primary objectives, but welfare of the society is.
However, they will also strive to make some profit to reinvest it back into the business and help it
grow.

Profit is not the same as cash flow! Profit is the surplus amount after total costs have been
deducted from sales. It includes all income and payments incurred in the year, whether already
received or paid or to not yet received or paid respectfully. In a cash flow, only those elements
paid in cash immediately are considered.

Importance of Profit to Private Sector Businesses

 Profit is the reward to the business owner for taking risks by investing resources into a
business.
 It is used to measure a business success and measure the performances of managers.
 It is used to decide whether or not to continue making or selling a product.
 It is used to finance the purchase of non-current assets and expand the business, etc. and
also attract investors to help finance business expansion.
What is the Difference between Profit and Cash?

 Money invested in a business or borrowed by a business will increase cash but not profit.
 Capital expenditure e.g. buying a new machine decreases cash but does not decrease profit.
 Credit sales increases profit but does not increase cash until the buyer pays.
 Cash pays the daily expenses not profit. Cash is important for the business at all times.
Profits become more important for the long term success of the business.

Income Statement
An income statement is a financial document of the business that records all income generated by
the business as well as the costs incurred by the business and thus the profit or loss made over the
financial year. It is also known as profit and loss account or statement of operations, or statement
of income.

The other major financial statements are” the balance sheet, - statement of account, statement of
cash flow, and the statement of shareholders equity.

A simple Income Statement

($000)
Sales Revenue 1250
Cost of Sales (900)
GROSS PROFIT 350
Expenses including interest paid (155)
NET PROFIT 195
Corporation Tax (35)
PROFIT AFTER TAX 160
Dividends (120)
RETAINED PROFITS FOR THE YEAR 40

Main features of an income statement

Sales Revenue = total sales
It is the amount made by the business from the sales of its goods or services. It is calculated by
multiplying price by the amount sold.
Cost of Sales = total variable cost of production + (opening inventory of finished goods)
– (closing inventory of finished goods)
Gross Profit = Sales Revenue – Cost of Sales
Expenses: all overheads/fixed costs
Net Profit = Gross Profit – Expenses
Profit after Tax = Net Profit – Tax
Dividends: share of profit given to shareholders; return on shares
Retained Profit for the year = Profit after Tax – Dividends. These retained earnings are then
kept aside for use in the business.

Uses of Income Statement

Income statements are used by managers to:

 know the profit/loss made by the business

 compare their performance with that of previous years’ and with that of competitors’. If
profit is lower than that of last year’s why it is falling and what can they do to correct the
issue? If it is lower than that of competitors’ what can they do to be more profitable and be
competitive in the market?
 know the profitability of individual products by preparing separate income statement for
each product. They may decide to stop production of products that are making losses.
 help decide what products to launch by preparing forecast income statement for the first
few years. Whichever product is forecast to have a higher profit, the business will choose to
launch that product

The trading account

It shows the difference between the costs of goods sold and the sales revenue, the gross profit.
Note: Cost of goods sold need not be the same as the total value of goods bought by the business.
Gross profit does not make any allowance for overhead costs or expenses. In a manufacturing
business the direct labor cost and the direct production costs will be deducted from the gross profit
before arriving at the Gross Profit Total. The gross profit is not the final profit of the business as
all the expenses has to be deducted.

The profit and loss account

It shows how the net profit is calculated. It begins with the gross profit calculated from the trading
account. All other expenses and overheads of the business are subtracted

Depreciation: is the fall in the value of a fixed asset over time

Balance sheets
It shows the value or worth of a business at a particular moment in time
Assets: are items of value that are owned by the business.
Fixed assets – (Land, buildings, equipment and vehicles) they are usually kept by the business for
more than a year. Most of the fixed assets depreciate over time.
Current assets – (cash, stocks and debtors) they are only held for a short period of time.

Liabilities: are the items owed by the business

Long-term liabilities – they are long term borrowings (they do not have to be repaid within one
year)
Current liabilities – borrowings which must be repaid within one year

Explanation of Balance sheet terms

Working capital (or net current assets): It is used to pay short term debts
Working capital = Current assets – Current liabilities
Net assets = Fixed assets + Working capital These assets must be paid for by money put into the
business in two ways : shareholders’ fund and long-term
Share capital – is the money put into the business when the shareholders bought ‘newly issued
shares’
Capital employed = Shareholders’ funds + long term liabilities
Capital employed = net assets

Class Activity

1. Rafiq is the Operations manager at a small factory. The business makes a range of soft drinks
using batch production. Last year Rafiq successfully introduced just-in-time inventory control,
based on an idea from one of the 40 employees. As the business is planning to expand, Rafiq
thinks it would be a good idea to change to flow production

(a) i. What is meant by ‘cost of sales’ ii. Give two examples of Overhead cost ?

(a) ii. Cost of rent / cost of maintenance of machines