Subsection of: Amira’s Story
Provided by the International Finance Corporation
Because the P&L reflects the trading that was carried out, not the movement in cash. The cash position is calculated separately to the Profit & Loss Account.
Because some of the cash in the bank is actually owed to someone else, like the supplier, the bank itself that lent the money or the investor (Amira’s Dad). The profit figure shows what would be left in the bank after all debts are paid and all monies have been received.
If all that had happened was the investment of $500, purchases of 400 all in cash, and sales of $600 all in cash, then the profit plus the investment would equal the cash balance. Because simple profit equals cash.
For this example, where we can easily see the solution, it might look like an over-complication. But imagine there were hundreds of purchases of thousands of different items at many different prices. The simple formula “value of stock at the start of the period ADD new purchases in the period, LESS value of stock at the end of the period” still works in exactly the same way.
Because it can be useful for lenders, investors and business owners themselves to see how the different elements of their business are doing. The different elements are:
- Trading – the buying and selling of goods and services
- Administration: the running costs of the business
- Financing: the costs of financing the business
Join the club. But don’t assume it is wrong or stupid. It can be very important in accounting terms. It is a method of spreading the cost of items that will be used by the business for many years (called Fixed Assets) over the estimated life of the item. In this case, it is the truck. Amira reckons she can use it for three years before it is no longer useful. So, to be fair to the businesses accounts, we spread the cost out over those three years at $50 per year, or about $4 per month. We would do the same for things like machinery, buildings, IT equipment, and furniture, because they have a significant value and will last for more than 1 year. We wouldn’t do it for things like stationery, photocopier toner, or IT accessories, because they are either small value or are not expected to last beyond one year.
The profit belongs to the business. It is essential to remember that the owner of a business and the business itself are considered separate people, both legally and for most tax purposes. This is especially so when the business is in the form of a limited company. If Amira owns all the shares in the company, then she owns all of it and can sell all the assets and pay off the debts, keeping the remaining money for herself. If someone else owns some shares, then the funds remaining have to be split in the same proportion as the shareholdings.
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