Capital, Profit, Loss - An understanding

Learn Accounting through an example

A poor, unemployed person (we shall call him Oberoi) decided to make his livelihood by selling vegetables going around houses in a locality.

Business

  • An activity undertaken with a motive to earn a profit.

The profit motive is inherent in business. Not that every business generates profits, but the motive behind every act/transaction in a business would be to aid the ultimate objective of making a profit.

Capital

  • Resources like money, buildings, and other assets with which a business is started and/or carried on

Mr. Oberoi could garner a small amount, 200/- in cash, with which he started the business activity. We say he brought in a capital of 200 in cash into the business.

Capital
200 Cash 200

Expenditure

  • Money spent on something

All the money that Mr. Oberoi has brought in as capital could be used for buying vegetables.

Purchases

  • Something acquired by purchase

Since the expenditure is on purchase of vegetables, it also called purchase expenditure or purchase.

Investment

  • Money that is invested with an expectation of profit

The money spent on buying vegetables can also be called an investment. However an investment may be for a short period or a long period of time, like in the case of investment in real estate. Thus for the purpose of this discussion we will consider the amount spent by Mr. Oberoi on buying vegetables to be expenditure.

Oberoi's daily routine

He goes to the wholesale market early in the morning, to buy fresh vegetables, which are generally available during that time, from wholesale vendors. He then roams around a locality for selling the vegetables to various households.

After buying vegetables from the wholesale market, Oberoi is in possession of 200 worth of vegetables.

Goods

  • Items that are offerred for sale by a trader or manufacturer during the course of their normal business activities
  • Merchandise
  • Stock

Vegetables are being used by Mr. Oberoi in the normal course of business as a trader. Vegatables would form his businesses's Stock/Goods.

To make profit Mr. Oberoi used to sell the vegetables at a price arrived at by adding a certain amount to his purchase price.

Income

  • The amount that is received or receivable on account of disposing off something.
  • Proceeds
  • Receipts

The amount that Mr. Oberoi receives or has to receive on selling vegetables would be his income. In general, it is called sales realisation or realisation on account of sale of goods.

Sales

  • Income received for goods and services

Since this income is on account of sales it is also termed sale proceeds, or sales realisation, or simply sales.

Profit

  • The excess of income over expenditure
  • The amount by which sale proceeds exceed the purchase cost
  • Gain
  • Loss

Profit

= Selling Price − Cost Price or

= Sale Proceeds − Cost of Purchase or

= Income − Expenditure

Loss

  • The amount by which investment exceeds realisation
  • The excess of cost price over selling price
  • Deficit
  • Profit

Loss

= Cost Price − Selling Price or

= Cost of Purchase − Sale Proceeds or

= Expenditure − Income

Day One

Oberoi, went to the wholesale market, bought vegetables with the 200 he had. He could only buy a few varieties with the limited amount of capital at his disposal. He then set out, on his trip around the locality, for selling vegetables.

Expenditure

= 200/

= Cost of Purchase

After buying the vegetables (stock/goods)

Capital
200 Stock/Goods 200

He arrived at a selling price for each of the varities of vegetables by adding a certain amount of profit to his purchase price. Since there were only a few varities, remembering the prices at which he bought and the price at which he had to sell them was not a problem.

Value

  • The amount of money that is considered to be a fair equivalent
  • The amount of money that would be foregone in exchange
  • Worth

Price

  • Value per unit quantity
  • Worth

Value, Price relationship

Value = Price × Quantity

⇒ Price =
Value
Quantity

Eg: The value of 5 kg goods is 80

⇒ Price of goods =
80
5 kg
=
80 16
5 1 kg
= 16/kg

End of day One

By the end of the day, Mr. Oberoi, sold all the vegetables he purchased in the morning. He counted the cash with him and found it to be 280. His realisation from the sale of vegetables i.e. sale proceeds is 280. He had 80 more (280 − 200) than he had started with.

Where did the extra 80 come from?

It is on account of the profit he made by selling vegetables.

Profit

= Sale Proceeds − Cost of Purchase

= Income − Expenditure

= 280 − 200

= 80

For day two

Cash available for investment in goods/stock is 280.

Capital
?
200
80
Cash 280

The extra 80 cash on account of the profit made on day one also would and should belong to Mr. Oberoi. Since this extra 80 can also be used as investment for purchasing vegetables on day two, we can say that Mr. Oberoi's capital is 280.

Capital
280
Cash 280

On acount of the profit made, Mr. Oberoi's capital increased from 200 to 280. From this we learn one of the fundamental understandings in accounting/business.

Profit increases Capital

As a business makes profits, the amount of capital available with it increases.

Oberoi's Capital at the end of day one or start of day two

= Capital at the start of day one + Profit made on day one.

= 200 + 80

= 280

Day two

Oberoi, went to the wholesale market, bought vegetables with the 280 available for investment in stock on day two, and then set out on his trip around the locality for selling vegetables.

Expenditure

= 280

= Cost of Purchase

After buying the vegetables (stock/goods)

Capital
280 Stock/Goods 280

Towards the end of day two

He noticed that there were certain items remaining, which, if unsold, would get spoilt and realise nothing. Therefore he started selling the remaining vegetables at a reduced price. This price at which he sold the vegetables was far less than the price at which he bought them.

End of day two

By the end of the day, Mr. Oberoi could sell all the vegetables he had with him. He counted the cash with him and found it to be 260. His sale proceeds (income) on day two from the sale of vegetables is 260. He had 20 less (260 − 280) than the amount he started with.

Why a shortage?

The shortage is on account of the loss he incurred in selling the vegetables.

Profit

= Sale Proceeds − Cost of Purchase

= Income − Expense

= 260 − 280

= −20

Or

Loss

= Cost of Purchase − Sale Proceeds

= Expense − Income

= 280 − 260

= 20

For day three

Cash available for investment in goods/stock is 260.

Capital
280 Cash
?
260
20

Compared to the beginning of day two, the shortage of cash to the extent of 20 is on account of the loss made on day two.

The loss would and should be borne by Mr. Oberoi. Since this 20 would not be available for being invested in purchasing vegetables on day three, we can say that Mr. Oberoi's capital is 260 only and not 280.

Capital
260
Cash 260

On acount of the loss incurred, Mr. Oberoi's capital decreased from 280 to 260. From this we learn one another fundamental understanding in accounting/business.

Losses decrease Capital

As a business incurs losses, the amount of capital available with it decreases.

Oberoi's Capital at the end of day two or start of day three

= Capital at the start of day two − Loss incurred on day two.

= 280 − 20

= 260