Financial statements

Business A2 · Finance and accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

The statement of profit or loss shows how much profit a business made over a period, usually one year. It starts with revenue and takes away costs step by step: gross profit, then profit from operations, then profit for the year. Any profit not paid out as dividends is kept as retained earnings.

The statement of financial position shows what the business owns (assets) and owes (liabilities) on one date. Net assets always equal equity, which is share capital plus reserves.

Two estimates affect both statements. Inventory is valued at the lower of cost and net realisable value. Depreciation spreads the cost of a non-current asset over its useful life.

Rules to remember

gross profit = revenue − cost of sales
profit from operations (operating profit) = gross profit − expenses
profit for the year = profit from operations − finance costs (interest paid, if any) − taxation; retained earnings = profit for the year − dividends
net current assets = current assets − current liabilities
net assets = non-current assets + net current assets − non-current liabilities = equity (issued shares + reserves)
Inventory is valued at the lower of cost and net realisable value (NRV = selling price − costs to complete and sell).
annual straight-line depreciation = (cost − residual value) ÷ useful life in years

Common mistake

Students treat depreciation as cash put aside to replace the asset. It is not a cash payment: it is an expense that lowers profit and lowers the value of the asset in the statement of financial position.

Worked example

A company has revenue of $600 000, cost of sales of $360 000 and expenses of $150 000. There are no finance costs. Tax is 20% of profit before tax and dividends are $30 000. What are its retained earnings for the year?

Gross profit = 600 000 − 360 000 = $240 000.
Profit from operations = 240 000 − 150 000 = $90 000.
With no finance costs, profit before tax is also $90 000. Tax = 20% × 90 000 = $18 000, so profit for the year = 90 000 − 18 000 = $72 000.
Retained earnings = 72 000 − 30 000 = $42 000.

Answer: Retained earnings = $42 000, which is added to reserves in the statement of financial position.

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