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

In a very simple sense, business implies something that is carried on with a motive to earn profit/income. 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 profit.

Capital

The resources like money and other assets with which a business is started and/or carried on is called Capital. Capital can also be understood as the investment made in the business.

Mr. Oberoi could only garner a small amount say 200/- with which he could start the business.

Oberoi's Capital = 200/-

Oberoi's daily routine : He used to go to the wholesale market early in the morning, to buy fresh vegetables, which are generally available during that time, from wholesale vendors. He then roamed around a locality selling the vegetables to various households.

After buying vegetables from the wholesale market, Oberoi possesses 200 worth of vegetables.

Goods/Stock

The items that are used for the purpose of business in the activity of buying and selling (regularly) are identified as Stock or Goods.

Vegetables being used by Mr. Oberoi for the purpose of his trade, they would form his businesses's Stock/Goods.

Value of Stock/Goods = 200/- [Vegetables].

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

Realisation

The realisation from the sale of goods/stock would be the cash he has collected by selling the vegetables.

Profit and Loss

Profit

= Selling price — Cost price
= Realisation — Investment

Loss

= Cost price — Selling price
= Investment — Realisation

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

Mr. Oberoi's Investment = 200/- [Stock/Goods].

Remembering the prices at which he bought the various varieties was not a problem. Thereby, he could arrive at a selling price by adding a certain amount of profit to his purchase price.

Price and Value

Value = Price × Quantity
⇒ Price =
Value
Quantity
⇒ Value of a unit quantity is the price.

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 evening, Oberoi, sold all the vegetables he purchased in the morning. He counted the cash with him at the end of the day. It was 280. Thus, his realisation from business 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 = Realisation - Investment
= 280 - 200
= 80

Beginning of day two : What is the capital Oberoi has for investment? Since he has 280 at the end of day one, he can use all that for purchasing vegetables on day two. Therefore his capital at the beginning of day two is 280.

Oberoi's Capital = 280.

What happened to his capital? Why? How?

His capital has increased from day one to day two by 80. The reason for this increase is the profit he made on day one.

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. Capital available with the business after making a profit would be a sum of capital and profit.

Oberoi's Capital for day two = Capital on day one + Profit made on day one.

During the course of day two : Oberoi, went to the wholesale market, bought vegetables with the 280 (his capital for day two) and then set out on his trip around the locality selling vegetables. Even on day two he did not find any difficulty in remembering the purchases prices so as to arrive at a selling price that would give him some profit.

After buying vegetables from the wholesale market,

Oberoi's investment = 280 in stock/goods.

Towards the end of day two : he noticed that there was certain stock left over which if he is unable to sell would get spoilt and would get nothing out of it. Therefore he started selling by reducing the 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 evening Oberoi sold all the vegetables he had with him. He counted the cash with him at the end of the day. It was 260. He had 20 less (260 − 280) than he started with.

Why a shortage? What happened to his 280/-?

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

Beginning of day three : What is the capital Oberoi has for investing? Since he has 260 at the end of day one, he can use all that for purchasing vegetables on day two. Therefore his capital at the beginning of day two is 260.

Oberoi's Capital = 260.

What happened to his capital? Why? How?

His capital has decreased from day two to day three by 20. The reason for this decrease is the loss he incurred on day two.

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. Capital available with the business after incurring a loss would be the difference of capital and loss.

Oberoi's Capital for day three = Capital on day two − Loss made on day two.