Table 1 shows the Trial Balance for the Works Co as on 1/01/2011.
Account Debit Rs. Credit Rs.
Sales Returns £9,100
Purchase Returns £6,300
Discount Allowed £6,000
Opening Stock £12,000
Electricity and Gas £7,200
Sundry expenses £4,300
Discount Received £5,200
Bank Overdraft £2,100
Long Term Loan £27,000
Rent and Rates £6,000
Table 1. Trial Balance for Works Co. as on 1/01/2011.
Debit and credit totals are equal, which means that ledger accounts were prepared correctly.
Table 2 represents Trading Account and Profit and Loss Account.
Rs. Rs. Rs. Rs.
To Opening Stock £12,000 By Sales £375,000
To Purchases £96,150 (less Sales Returns) -£9,100 £365,900
(less Purchase Returns) -£6,300 By Closing Stock £10,000
To Gross Profit £274,050
Profit and loss account
To Salaries £63,000 By Gross Profit £274,050
To Rent and Rates £6,000 By Discount Received £5,200
(less rent prepaid) -£1,500 £4,500
To Discount Allowed £6,000
To Electricity and Gas £7,200
(plus unpaid electricity bill) £800
(plus unpaid gas bill) £700 £8,700
To Sundry Expenses £4,300
To Depreciation on Equipment £2,200
To Provision for Bad Debts £850
To Net Profit £189,700
Table 2. Trading and Profit and Loss account for Works Co. for the year ending 01/01/11
Finally, in order to get an overview of the state of affairs of the business for a particular date, it is necessary to prepare the balance sheet for a particular date. Table 3 shows the balance sheet of Works Co. as on 01/01/2011.
Liabilities Rs. Rs. Assets Rs. Rs.
Current Liabilities Fixed Assets
Creditors £3,600 Equipment £22,000
Bank Overdraft £2,100 (less Depreciation) -£2,200 £19,800
Unpaid Electricity Bill £800 Premises £216,000
Unpaid Gas Bill £700 Vehicles £15,750
Long-term liabilities Current Assets
Long Term Loan £27,000 Cash £1,700
Capital (less new provision) -£850 £7,650
Capital £50,000 Closing Stock £10,000
Net Profit £189,700 Prepaid Expenses £1,500
(less Drawings) -£1,500 £188,200
Table 3. Balance Sheet for Works Co. as on 01/01/2011
1. Trial Balance
The goal of preparing the Final Accounts is to determine final results of the company’s operations during a given period, to analyze its financial viability and to prepare the accounts for the next financial period (Tulsian, 2002).
First of all, it is necessary to prepare the Trial Balance. The purpose of the Trial Balance is to check the accuracy of balances for ledger accounts, to prepare information for the balance sheet and final accounts, and to help identify possible errors in this process.
Account balances are associated with debit or credit side of the balance to construct a Trial Balance. Accounts associated with purchases, expenses and assets are classified as debit side of the Trial Balance, and accounts associated with sales, receipts and liabilities are classified as the credit side of the Trial Balance (Tulsian, 2002). After constructing the Trial Balance, totals for its debit and credit side should be equal. Otherwise, there was an error in the process of ledger preparation (or in the preparation of the Trial Balance), and it should be corrected prior to preparing other Final Accounts.
2. Trading Account
The next step is to prepare Trading Account as well as Profit and Loss Account. The Trading Account is prepared to measure Gross Profit (the result of trading). This account is used to analyze whether the company has profits or losses, and can also be used to compare the trading results with previous periods. This account also allows to determine the value of Gross Profit, which is an important part of many financial ratios.
On the debit side of Trading Account, there are opening stock, net purchases (including credit and cash purchases) associated with business activity of this period (no long-term purchases are included in this account) and direct expenses, associated with business activity of this period (Gabriel, 2010). On the credit side of this account, there are sales (credit and cash) and closing stock (Gabriel, 2010). The difference between the totals of these sides is Gross Profit.
3. Profit and Loss account
Profit and Loss Account is prepared to determine net business results (Net Profit or Loss). In this account, direct expenses and income are included. Credit side of this account includes Gross Profit (submitted from Trading Account), all abnormal gains, indirect incomes and net loss transferred to Capital Account (Gabriel, 2010). Debit side of this account contains management expenses, expenses for selling and distribution, all abnormal losses, financial expenses, net profit transferred to Capital Account and Gross Loss (submitted from Trading Account) (Gabriel, 2010). The difference between the totals of debit and credit side of this account yields Net Profit (or Net Loss), which is further shown in the liability section of the Balance Sheet.
4. Balance Sheet
Balance Sheet is an important financial document stating the assets and liabilities of the company as to a specified date (in our case, 01/01/2011). It represents a summary of account balances for the target date, and allows to evaluate the nature and value of assets as well as the amount of the company’s liabilities to this date. Balance Sheet is the primary document proving the financial solvency of the company and its state of affairs compared to competitors and to previous periods of own activity.
Balance Sheet is not an account and it does not have debit or credit side; instead, Balance Sheet has Liabilities and Asset sides. The Liabilities side includes such sections as Capital, Current Liabilities and Long-Term Liabilities. It can also include Contingent Liabilities. On the Asset side, there are Current Assets and Fixed Assets sections, and this side can also include Investments section (Tulsian, 2002).
Totals of both Liabilities and Asset sides of the Balance Sheet should be equal. This fact follows from the basic accounting equation: Assets = Liabilities + Capital. It is possible to reformulate this equation in the following way: Equity = (Current Assets – Current Liabilities) + (Non-current assets – Non-current liabilities), or Debt + Equity = Working Capital + Non-Current Assets. This equation, in its turn, can be reformulated as Net Assets = Capital.
Gross Profit Margin, Net Profit Margin and Return on Capital Employed relate to profitability ratios (Benedict & Elliott, 2001). These ratios are used to analyze whether the company’s operations are profitable with regard to absolute financial results, previous performance of the company and average industry profitability. Gross profit margin is calculated as the gross profit divided by sales multiplied by 100%, and net profit margin is calculated as the net profit divided by sales multiplied by 100% (Benedict & Elliott, 2001). Return on Capital Employed is determined as the relation of net profit by capital employed, multiplied by 100% (Benedict & Elliott, 2001). Since gross profit is used to cover future savings and additional expenses, this ratio is often used to compare the profitability of competitors against each other. Net Profit Margin, in its turn, shows the company’s earnings with regard to every dollar of sales, and is commonly used as the primary measure of profitability as well as the measure for comparing industries with each other (Gabriel, 2010). The Return on Capital Employed shows the actual profitability of the company’s capital, and this value should be above the company’s interest rate applied to borrowings.
For Works Co., gross profit is £274,050, and sales are equal to £375,000; thus, Gross Profit Margin is £274,050*100%/£375,000=73.08%.
Net profit is £189,700, and Net Profit Margin is £189,700*100%/£375,000 = 50.58%. Both these values indicate that the profitability of Works Co. is rather high: Gross Profit Margin is remarkably high, which means that the company has a lot of space for investment and development, and Net Profit Margin is also rather high, which means that the company’s operations are highly effective. For more precise analysis it would be useful to compare the results of Works Co. with main competitors, since in different industries the values of average net profit margin might significantly differ.
Capital employed for Works Co. includes Capital, Net Profit and Long-Term Liabilities. Thus, Capital Employed = £50,000+£188,200+£27,000 = £265,200. Return on Capital Employed = £189,700*100%/$265,200 = 71.53%. This value is also very high, which indicates that the best investment for the company is to expand its business, and Works Co. can afford almost any loans in order to expand the operations and develop. Overall, profitability of Works Co. is very high and it is most likely one of the top performing companies in the industry.
Current Ratio and Acid Test are the measures of the company’s liquidity, i.e. show whether the company has enough cash to cover its short-term liabilities. Current Ratio is calculated as the relation of current assets to current liabilities, and Acid Test (also referred to as the Quick Ratio), is determined as the relation of Current Assets less Inventory divided by Current Liabilities (Benedict & Elliott, 2001). While Current Ratio shows the ability of the company to pay its short-term liabilities with its short-term assets, Acid Test is a more strict measure of liquidity, because it excludes inventory and prepaids from current assets, and focuses on the most liquid assets. If the company’s Acid Test value is lower than 1, this is a warning sign, and if Current Ratio is also below 1, this means that the company is experiencing significant cash shortages (Gabriel, 2010). If there is a significant difference between these ratios, it means that the company is too dependent on inventory.
For Works Co., current liabilities are £7,200, current assets are £20,850, and current assets less stock and prepaid expenses include only Cash (£1,700) and Debtors (£7,650), totaling to £9,350. Thus, Quick Ratio for Works Co. is equal to £20,850/£7,200 = 2.90, and Acid Test is equal to £9,350/£7,200 = 1.30. Both values are above 1, and it is possible to conclude that Works Co. does not have any problems with liquidity, and its short-term financial position is good. There is a significant difference between the values of Acid Test and Quick Ratio, showing that Works Co. is quite dependent on inventory, but since its Acid Test is above 1, this feature does not affect the financial stability of the company. It is possible to conclude that financial position of Works Co. is rather strong, and it is the right time for investment and further expansion for the company.
Benedict, A. & Elliott, B. 2001. Practical accounting. Pearson Education.
Gabriel, S.J. 2010. Financial Accounting. Tata McGraw-Hill Education.
Rich, J., Jones, J. & Mowen, M. 2011. Cornerstones of Financial Accounting. Cengage Learning.
Tulsian, P.C. 2002. Financial Accounting. Pearson Education.