Topic 3

Kaimosi Friends University
Directorate of Open Distance and E-Learning
TOPIC THREE: INVESTMENT ANALYSIS
3.0 INTRODUCTION
Welcome to our second topic of the module. In topic one, we discussed book keeping and
especially how to record transactions. In this topic, we are going focus on how to determine the
profitability of the business. We shall discuss how to prepare the final accounts of the business
that show the profits earned or the loss suffered. Further, we shall consider the basic ratios that
reveal the performance of the business.
3.1 SPECIFIC LEARNING OUTCOMES
By the end of this topic, you should be able to:

• Prepare the final accounts of the business
• Compute the financial ratios of the business
• Describe the viability of the investment
3.2 SECTIONS OF THE TOPIC

In this topic, we shall cover the following sections:
Section 1: Final accounts
Section 2: Investment analysis
Section 3: Financial ratios
These sections are discussed below.
3.2.1 FINAL ACCOUNTS
The financial statements which are most important statements for internal and external use are the
income statement and the balance sheet. These financial statements are prepared to find the profit
made by a business during a trading period. These statements are known as final accounts and they
consist of the following:
The Income Statement: The income statement of a firm consists of the

trading account and the profit and loss account. These accounts provide a summary of the accounts
that will have affected the profit or loss position of the business in a particular trading period.
These are explained as hereunder.
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1. TRADING ACCOUNT
This is a financial statement which shows the revenue from sales, cost of sales, and the gross profit
arising during the accounting period. It is used to ascertain the gross profit or gross loss of the
business.
Gross profit is the sales less cost of goods sold. It represents the difference between sales revenue
and purchase price of goods sold (Sales – Cost of goods sold). However, when the purchase price
exceeds the sales then we have a gross loss. To obtain cost of goods sold add net purchases(
purchases – purchase returns or otherwise returns outwards) and carriage inwards to the opening
stock then subtract closing stock at the end of the period
Example
At 31st Dec. 2006, Kamau’s accounts disclosed the following balances: Purchases 25,000.00,
Sales 35,000.00, Stock at 1st Jan. 2006 as 5,000.00 and Stock at 31st Dec.2006 as 6,000.00.
Kamau’s Trading A/c
For the Year ended 31st Dec. 2006.
Opening Stock 5000 Sales 35000
Add Purchases 25000
Cost of good available for sale 30000
Less Closing Stock 6000
Cost of goods sold 24000
Gross Profit c/d 11000 . .
35000 35000
Gross profit b/d 11,000
2. PROFIT AND LOSS ACCOUNT
It is a financial statement which shows the net profit or loss of a business for a given period. It is
used to ascertain the net profits of the business. Net Profit (NP) is the difference between gross
profit and selling expenses, distribution expenses and administration expenses of the business. It
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may be defined as excess of gross profit over the expenses of the business incurred to conduct the
business transaction.
Give examples of business operating expenses and incomes?
Some examples of business operating incomes include rent received, commission earned,
reduction in the provision of bad and doubtful debts and dividend received while operating
expenses include salaries and wages paid, rent paid, discount allowed, depreciation and increase
in the provision of bad & doubtful debts.
The Net profit or loss obtained in the profit and loss account is transferred to the capital account
of balance sheet. The net profit is added to the capital account while the net loss is subtracted from
the capital account.
In general, the preparation of income statements helps to ascertain the profits or losses incurred by
the business. This always requires the preparation of a trading, profit and loss account which takes
the following steps.
1. To the opening stock, add net purchases (purchases less returns outwards (purchase returns)
and carriage inwards and then subtract the value of closing stock to obtain the cost of goods
sold
2. To sales, subtract sales returns (returns inwards) to ascertain net sales.
3. The difference between cost of sales and the net sales gives gross profit (when the cost of
sales is less the net sales) or gross loss (when net sales is less cost of sales).
4. To gross profit, add all other revenues (incomes) to the business to obtain total receipts
5. To gross loss, add all costs incurred for the smooth running of the business (expenses) to
obtain total expenses
6. The difference between total receipts and total expenses gives net profit (when total
revenues exceed total expenses) or net loss (when total expenses exceed total receipts).
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The following trial balance was extracted from the books of Biashara Enterprises as at
st
31 December 2009.
Item Dr (Ksh.) Cr (Ksh.)
Opening stock 3000
Purchases 4050
Sales 6620
Carriage inwards 90
Returns outwards 80
Returns inwards 120
Salaries and wages 520
Electricity 190
Rent 240
General expenses 70
Carriage outwards 110
Discount allowed 150
Insurance 500
Stationery 360 . .
6700 6700
Additional information: closing stock was valued at Ksh. 550
Required: prepare Biashara Enteprises trading, profit and loss account for the year ending 31 st
December 2009.
DEPRECIATION: As seen earlier, all assets except land depreciate or

loose their deported value over a period of time. This means that a fixed asset except land is
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expected to loose some of its usefulness as it gets older. Three factors are considered in
determining the amount of depreciation expense to be recognized each period. These are the fixed
asset’s initial cost, its expected useful life and the residual value, scrap value, salvage value, or
trade-in value. A fixed asset’s residual value or expected useful life at the end of its useful life
must be estimated at the time the asset is placed in service. There are three methods used in
computing depreciation for its depreciable assets namely the straight-line, units of production, and
declining-balance.
The straight line method provides for the same amount of depreciation expense for each year of
the asset’s useful life. It is computed by D = (C- S)/N where: D: - Annual charge for depreciation,
C: - Original cost of asset, S: - Scrap value (Residual value) and N: - Number of years (expected
life of the asset).
For example, assume that the cost of a depreciable asset is £24,000, its estimated residual value is
£2,000 and its estimated life is 5 years, then,
The annual depreciation = (Cost – Estimated residual value)/estimated life
=(£24,000 – £2000)/5 = £4400.
Now, the annual depreciation may be converted to a percentage of the depreciable cost. The
percentage is determined by dividing 100% by the number of years of useful life. The annual
depreciation of £4400 can be computed by multiplying the depreciable cost of £22,000 (£24,000
– £2000) by 20% (100%/5).
The straight line method is simple and is widely used as it provides a reasonable transfer of costs
to periodic expense when the assets use and the related revenues from its use are about the same
from period to period.
Units of Production Method is when the amount of use of a fixed asset varies from year to year,
the unit of production method is appropriate. The units of production method provides for the same
amount of depreciation expense for each unit produced or each unit of capacity used by the asset.
To apply this method, the useful life of the asset is expressed in terms of units of productive
capacity such as hours or miles. The total depreciation expense for each accounting period is then
determined by multiplying the unit depreciation by the number of units produced or used during
the period. For example, assume that a machine with a cost of £24,000 and an estimated residual
value of £2,000 is expected to an estimated life of 10,000 operating hours. The depreciation for a
unit of one hour is computed as follows:
Cost – Estimated Hours = Hourly depreciation i.e. £24,000 – £2000/10000 =£ 2.20
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Declining-Balance Method provides for a declining periodic expense over the estimated useful
life of the asset. It is also called the reducing balance method. This is calculated as D = R(C-A)
where: R = 1- n√S/C, R:-Rate of depreciation, A:-Accumulated depreciation.
Example
A business has just bought a machine for £8,000. It will be kept in use for 4 years, when it will be
disposed off for an estimated amount of £500. Prepare a comparison of the amounts charged as
depreciation using both methods.
Solution:
Using Straight Line Method, depreciation is computed as:
Cost of Asset – Residual Value/No. of useful years = £ (8000 – 500)/4 = 7500/4 = £1875.
Thus,
For Year 1: 8000 – 1875 = 6125

For Year 2: 6125 – 1875 = 4250
For Year 3: 4250 – 1875 = 2375
For Year 4: 2375 – 1875 = 500.
Using the Reducing Balance Method and Take 50% of the Asset Value then
For Year 1: 50% X 8000 = £4000. Hence new value is 8000- 4000 = £4000
For Year 2: 50% X 4000 = £2000. Hence new value is 4000 – 2000 = £2000.
For Year 3: 50% X 2000 = £1000. Hence new value is 2000– 1000 = £1000
For Year 4: 50% X 1000 = £500. Hence new value is 1000 – 500 = £500
This illustrates that using the reducing balance method has a higher charge for depreciation in the
early years and lower charges in the later years.
Final Accounts Adjustments: Their purpose is to show the true profits

(Gross & Net) of the business and to show the correct view of the state of the business financial
affairs at a particular date. They include depreciation of fixed assets (minus in fixed assets), the
provision for bad and doubtful debts (minus from debts), accruals (Add current liabilities) and pre-
payments (add current assets). The following adjustments are performed in order establish the true
value of expenses and other items.
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Accruals (Outstanding Expenses): If annual accounts of a business are prepared on 31st

December some expenses like rent, wages, and salaries may not be paid in December but in the
following year. Such expenses are called outstanding expenses or accrued expenses. Outstanding
expenses are debited in the trading, profit and loss account along with concerned expenditure and
also recorded in the liability side of the balance sheet.
Pre-Payments/Prepaid expenses: If expenses of next year are paid during the trading period then
such are known as pre-payments. Such advanced payments are deducted from concerned
expenditure in the debit side of the profit and loss account and they also appear on the asset side
of the balance sheet.
Provision for bad debts: Experience shows that some part of outstanding debts of the last date of
the accounting period become irrecoverable. The anticipated loss must be taken into account for
the calculation of the correct amount of Net Profit. For this purpose a provision for bad & doubtful
debts is calculated and is charged into the profit & loss account. This provision is credit to the
provision for bad &doubtful debts and it is shown as a deduction from the total debtors in the
balance sheet.
Example
The following balances were extracted from the books of XY Company as at 31st December, 2006.
Stock as at 1st Jan 2006 50,000 Land and buildings 240,000
Debtors 90,000 Purchases 280,000
Salaries & Wages 35,000 Fixtures & Fittings 25,000
Sales 520,000 Discount allowed 7,500
Discount received 4,500 Land & Machinery 140,000
Rates 5,600 Advertising 10,400
Insurance 3,800 General expenses 7,200
Provision for bad debts 1,800 Creditors 58,000
Cash in hand 2,400 Bank overdraft 18,600
Drawings 6,000 Capital 300,000
Additional Information
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1. Depreciation is provided on straight line method on land and machinery at 10% per annum
and fixtures and fittings at 15%.
2. Provision for bad debts is to be increased to an amount equal to 40% of sundry debtors.
3. Prepaid insurance 500
4. Rates accrued 400
5. Closing stock was valued at 60,000
6. During the year the owner of the business took goods worth Kshs. 2000 for personal use.
Required: Prepare a Trading Profit and Loss account of the business for the year ended 31 st
December, 2006.
Solution :
XYZ company Trading Profit and Loss Account for the Year ended 31st December 2006
Dr (Kshs.) Cr (Kshs.)
Sales 520,000
Opening stock 50,000
Add Purchases 280,000
Goods Available for sale 330,000
Less closing stock 60,000
Cost of goods sold 270,000
Gross Profit 250,000
Add discount received 4,500
254,500
Expenses
Salaries & Wages 35,000
Discount allowed 7,500
Rates 5600
Add Rates accrued 400 6,000
Advertising 10,400
Insurance 3,800
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Less Insur. Pre-paid 500 3,300
General Expenses 7,200
Provision for bad debts 34,200 (1)
Dep. on Plant & mach. 14,000 (2)
Dep. on fixtures & fit. 3,750 (3)
Total expenses 121,350
Net Profit 133,150
254,500 254,500
EXPLANATORY NOTES
(1) Provision for bad debts = 40% X 90,000 = 36,000. Hence, 36,000- 1,800 = 34,200
(2) Depreciation on plant & machinery = 10% X 140,000 = 14,000
(3) Depreciation on fixtures & fittings = 15% X 25,000 = 3,750
3. BALANCE SHEET
A balance sheet is a financial statement showing the financial position of a business at a specific
date. It shows what the business is owing to others and owning. It thus shows the assets, liabilities
and capital of a business as at a given date. Hence is used in the business to prove the validity of
the accounting equation.
Now, let us discuss further the concept of capital. Firstly and as seen earlier, capital is a special
liability. As a liability, it is subject to change at the end of the trading cycle due to the following
1. Drawings: this includes cash or items taken from the business by the owner for private use.
This therefore reduces the capital of the business
2. Profits: this refers to excess sales over the cost of sales and other expenses. This is therefore
the net profit attributed to the owners and hence results in an increase in capital of the
business
3. Losses: this is a situation where the cost of sales exceeds the value of sales and other trading
incomes. This is thus the net loss that the owner will suffer as this will reduce the capital
of the business.
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4. New investments: this refers to additional assets or cash brought into the business by the
owner. This therefore increases the value of capital in the business.
Secondly, we discussed that capital may be categories as equity capital or loan capital. However,
capital is further classified as follows:
1. Capital owned: this is the total amount invested in the business by its owners. It is also
called owners or equity capital. Thus capital owned can be expressed as cCapital at start
plus (profits and new investments) less (drawings and losses)
2. Borrowed capital: this is the sum total of money borrowed from financial institutions such
as commercial banks and development finance companies. This is also called loan capital
3. Working capital: this refers to the excess current assets over current liabilities i.e current
assets less current liabilities. This form of capital is important as it is used to measure the
solvency of the business i.e the ability of the business to settle its debts from its internal
sources. It is also used to show if the assets of the business are underutilized in the running
of the business.
4. Fixed capital: this is the sum total of all the fixed assets in the business.
5. Working capital: this refers to the sum total of all the business finances available for its
operations. It is thus the sum of capital owned and borrowed capital or fixed capital and
working capital.
Ensuing from the above discussion, let us now present the balance sheet in the following examples.
Example 1
Consider the above example on XYZ Company, the balance sheet will thus be as follows.
XY Company Balance Sheet for the Year ended 31st Dec. 2006
Fixed Assets
Shop premises 50,000
Fixtures & Fittings 13,000

Fixed capital 63,000
Current Assets
Stock 8,900
Debtors 11,000
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Prepayments (rent) 200
Bank 10,400
Cash 4,800
35,300
Less Current Liabilities
Creditors 12,800
Accruals (electricity) 300 13,100
Working Capital 22,200
Capital employed 85,200
FINANCED BY
Capital 43,000
Add Net Profit 29,400
72,400
Less withdrawals 10,200

capital owned 62,200
Add long term liabilities (e.g. loan) 23,000
85,200
Example 2
Mr. Wasike has given you the following balances extracted from his books as at 30th September
2008.
Item Amount Item Amount
Cash at hand 1,200 Cash at bank 11,000
Stock at (1/9/2008) 21,000 Debtors 8,000
Creditors 10,000 Returns inwards 500
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Sales 56,000 Purchases 20,500
Capital 14,900 Salaries 4,000
Water & Electricity 600 Postage 200
Drawings 900 Stock (30/9/2008) 13,500
Furniture & Fittings 7500 Motor Van 35,000
Loan from ICDC 30,000 Rent received 1,200
Office rent 1,700
Required:
a) Prepare a Trial Balance for the period ending 30/9/2008.

b) Prepare his Trading, Profit & Loss Account for the month.
c) Prepare his balance sheet as at 30/9/2008.
Solution
(a) Mr. Wasike’s Trial Balance for the period ending 30th September 2008
Details Dr. Cr.
Cash at hand 1,200
Cash at bank 11,000
Stock at (1/9/2008) 21,000
Debtors 8,000
Creditors 10,000
Returns inwards 500
Sales 56,000
Purchases 20,500
Capital 14,900
Salaries 4,000
Water & Electricity 600
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Postage 200
Drawings 900
Furniture & Fittings 7500
Motor Van 35,000
Loan from ICDC 30,000
Rent received 1,200
Office rent 1,700 . .
112,100 112,100
(b) Mr. Wasike’s Trading Profit & Loss Account for the year ended 30/9/2008
Sales 56,000
Less Returns inwards 500
Net Sales 55,500
Less: Cost of Sales
Opening stock 21,000
Add purchases 20,500
Cost of goods available for sale 41,500
Less closing stock 13,500 28,000
Gross Profit 27,500
Add Rent received 1,200
Total income 28,700
Less Expenses
Salaries 4,000
Water 600
Postage 200
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Office rent 1,700 6,500
Net Profit 22,500
(c) Mr. Wasike’s Balance Sheet as at 30/9/2008
Fixed Assets Shs.
Motor van 35,000 Capital 14,900
Furniture & Fittings 7,500 42,500 Add Net Profit 22,200

37,100
Current Assets Less Drawings 900 36,200
Cash at hand 1,200 Add loan (ICDC) 30,000
Cash at bank 11,000 Creditors 10,000 40,000
Closing stock 13,500
Debtors 8,000 33,700
76,200 76,200
Example 3
The following Trial Balance was extracted from the books of James as at 31st December 2009.
James Trial Balance as at 31st December 2009
DR (Ksh.) CR(Ksh,)
Sales 67,000
Purchases 42,600
Lighting & heating expenses 1,900
Rent 2,400
Wages: Shop Assistant 5,200
General expenses 700
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Carriage outwards 1,100
Buildings 20,000
Fixtures & Fittings 7,500
Debtors 12,000
Creditors 9,000
Bank 1,200
Cash 400
Drawings 9,000
Capital 31,000
Stock (at December 2008) 3,000 . .
107,000 107,000
Required: Using the information from the Trial Balance,
a) Prepare James’s Trading Profit & Loss Account.
b) Prepare a Balance Sheet as at the last day of the business.
Solution:
(a) James Trading and Profit and Loss Account for the Year ending 31st December 2009
Dr(Kshs.) Cr(Kshs)
Sales 67,000
Less cost of goods sold:
Opening stock 3,000
Add Purchases 42,600
45,600
Less Closing stock (5,500) 40,100
Gross Profit 26,900
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Less Expense:
Wages 5,200
Lighting & heating expenses 1,900
Rent 2,400
General expenses 700
Carriage outwards 1,100 11,300
Net Profit 15,600
(b) James Balance Sheet as at 31st December 2009
Kshs. Kshs.
Fixed Assets
Buildings 20,000
Fixtures & Fittings 7,500 27,500
Current Assets
Stock 5,500
Debtors 12,000
Bank 1,200
Cash 400
19,100
Less Current Liabilities
(Creditors) (9000) 10,100
37,600
Financed by:
Capital: Balance as at 1st Jan 2009 31,000
Add Net Profit for the year 15,600
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46,600
Less Drawings (9000)
37,600
2.2.2 INVESTMENT ANALYSIS
Investment: this refers to commitment of funds into a business for purpose

of returns in future. Thus an individual who enters into a business expects to get returns in terms
of profits. It is however important to note that sometimes businesses incur gross loss and end up
getting a net profit as a result of the other trading activities of the business. Thus gross loss doesn’t
imply there will be a net loss at the end of the financial period. It is necessary at this point to look
at circumstances under which gross loss may occur in a business. This include when there is
1. Slow movement of stock.

2. Drawing in stock-the owner of goods withdraws some goods for personal use.
3. Poor customer relationship resulting to poor sales.
4. Inadequate advertising.
5. Some goods may be stolen or vandalized.
6. Tight competition in the market.
7. Some goods may become obsolete.
What other reasons may cause gross loss in a business?
Ensuing from this, there is need therefore to think critically on what to invest in. Below are some
considerations you can make in order to make a viable investment.
1. Return investment – include returns such as interest, profit etc. Usually the higher the
returns, the better the investment.
2. Security of investment- one should invest where there are fewer or minimal risks.
3. Degree of liquidity- this refers to how easy the investment can be converted into cash. For
a viable investment there is need to invest where it is conveniently easy to convert an
investment into cash.
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4. Pay back period- this is how long it takes for an investment to pay back the initial capital
invested. Usually, invest where it takes a short period to get back the initial capital invested.
5. Tax policy-invest in areas whose profits are tax-free or have a lower tax rate.
6. Growth rate – invest in activities whose funds value appreciate with time rather than those
that depreciate.
Mr. XYZ has been retrenched from his job and given Kshs. 3,000,000 as a lump
sum and intends to venture into business. He is undecided as to whether to invest
in matatu business or build rental houses in an upcoming town and approaches you
with your classmate to advise him on which option he should invest in. Discuss and
advise what Mr. XYZ should invest in.
2.2.3 FINANCIAL RATIOS
These are measures that indicate the performance of an investment. They provide quantities which
show how the level of success of a business. Before we discuss some basic ratios, let us first
highlight the advantages and disadvantages of ratios in analyzing the performance of a business.
MERITS OF FINANCIAL RATIOS
1. Analysis of financial position of business-ratios help to make investment decisions

especially those relating to lending and borrowing.
2. Simplify accounting figures- ratios summarize and systemize financial figures for easy
understanding. They often give relationship that exists between different segments of a
business.
3. Assesses the operational efficiency of a business- they assists in revealing liquidity
profitability, solvency or insolvency of a business.
4. Forecasting business trends for successive financial years i.e shows upward or downward
trend of business operations.
5. Locate weak points of a business useful in both short term and long term planning of
business activities.
6. Provide comparison of the performance of various departments within a firm.
DEMERITS OF FINANCIAL RATIOS
1. Give false results if incorrect accounting data is used eg if stock is overstated/understated,

the ratio will give a false impression of the business.
2. Are based on historical data and given that business world is dynamic, changes in the
market structure may not be revealed.
3. Changes in the price level of commodities render comparison for various years difficult.
4. Can’t act as a single denomination for comparison of two different firms operating under
two different environments e.g monopolistic and competitive environment.
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Now, to determine the viability of the investment, the following are the basic
ratios that are necessary for evaluating the performance of the business
1. Average stock- this is the average value of stock held by a business. It is computed by
Average Stock = (Opening stock + closing stock)/2
Interpretation: A high value shows low movement of stock and hence the proportion of money
invested is tied in stock.
2. Rate of Stock Turnover (ROST) - this reveals the number of times a business was re-stacked
during the trading period. It is calculated as
cos tofsales
R.O.S.T =
averagestock
Interpretation: A higher rate (usually more than 4) shows faster movement of stock
3. Creditors ratio – this establishes the average credit period given by creditor’s to settle their
accounts. It is computed as
creditors
Creditors ratio = x365days
crditpurchases
Interpretation: usually 30 days are taken to be a low credit ratio while 60 days are taken to be a
high ratio.
4. Debtor’s ratio- this is used to establish the average credit period allowed to debtors to settle
their accounts. It is determined as
debtors
Debtor ratio = x365days
crditsales
Interpreted similarly to creditors ratio above
5. Acid test ratio/quick ratio/liquidity ratio- this measures the precision with which a business
can be able to meet its debts without selling all the stock. It is determined by
currentassets − stock
Quick ratio =
currentliabilities
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Interpretation: A ratio of 1:1 is taken to be normal while a high ratio (eg 3:1) means high rate of
cash is not utilized.
6. Current ratio – this measures the capability of the business to pay its debtors. It’s computed
currentassets
as Current ratio =
currentliabilities
Accepted ratio is 2:1 while a higher ratio (e.g. 3:1) means the business is able to pay its bills in
time,
7. Rate of return on capital (RORC) = this measures the returns on capital invested and is
computed as
netprofit
RORC= x100
capital
The following information was extracted from Pesa’s books of accounts
Stock 1/1/05 40,000 bank overdraft 40,000
Stock 31/12/05 60,000 Creditors 50,000
Net Sales 354,000 Capital 250,000
Net Purchases 320,000 Indirect expenses 4,000
Stock 90,000 Debtors 70,000
Cash 20,000
Required: calculate the following ratios- average stock, ROST, Return on capital, current ratio,
liquidity ratio, Debtor ratio, creditors’ ratio and comment on the performance of the business.
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ASSIGNMENT
Kimtai started Business on 1/1/2008 by putting £60,000 into a bank account for the business.
2/1/2008, he paid sh.480 by cheque for rent for the two months January and February
2/1/2008, bought warehouse fixtures paying by cheque immediately for sh.7200.
3/1/2008, withdrew sh.900 cash from the bank for business use.
4/1/2008, paid wages in cash for three weeks of January sh.720.
5/1/2008, bought goods of sh.4200 paying for them immediately by cheque.
6/1/2008, bought goods on credit from T. Price sh.1800, F. Radcliffe limited sh.7200, C. Norton
& Co. sh.3,300.
8/1/2008, bought motor van by cheque for sh.14,400.
11/1/2008, paid for motor expenses sh.90 by cash.
12/1/2008, sold goods on credit to K. Kitchen limited for sh.1920 and E. Griffith for sh.4200.
13/1/2008, cash sales sh.840
15/1/2008, paid for light and heat by cheque for the 1st two weeks of January sh.480
16/1/2008, paid insurance by cheque sh.720 for the 12 months to 31st Dec 1995
19/1/2008, bought goods on credit from P. Goddard for sh.9600
21/1/2008, sold goods on credit to k. Kitchen limited for sh.20,400 and N. Fryer sh.720
24/1/2008, Kimtai withdrew sh.1,500 by cheque for his own personal use.
26/1/2008, received cheque from E. Griffith sh.4095, after deducting sh.105 cash discount. Also
received a cheque from K. Kitchen on account by sh.3000
27/1/2008, returned goods to C. Norton & Co. sh.720, and also returned goods to F. Radcliffe
sh.600
29/1/2008, paid by cheque after deducting 5% cash discount to the amounts of T. Price and P.
Goddard
30/1/2008, Goods returned to us (Kimtai Business) by K. Kitchen limited sh.204 and N. Fryer
sh.120
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31/1/2008, Kimtai withdrew sh.120 cash for his personal use.
1. Enter the above transactions in the books of Kimtai, balance off the accounts, and extract a trial
balance.
2. Prepare Trading Profit and Loss Account and a Balance Sheet for the month ended 31st January
2008.
3. Comment on the solvency of Kimtai business.
3.3 SUMMARY
In this topic we have learnt that investment is commitment of funds for returns in future. The
returns are usually in form of profits enjoyed at the end of the investment. These profits are
determined by preparing final accounts namely the trading account to establish the gross profit and
the profit and loss account to determine the net profit of the business.
We have also discussed how to evaluate the financial position of a business by preparing a balance
sheet. This in essence confirms the validity of the fundamental accounting equation discussed in
topic one.
Finally, we have discussed how to determine the viability and performance of an investment by
computing financial ratios that help explain the solvency of the business.
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3.4 SELF CHECK
SELF CHECK 2
1. The following balances were extracted from the accounting records of John as on December
31st 2011.(the currency is the Kenya shilling).
Item Amount Item Amount
Capital 250,000 Stock (1/12/2011) 25,000
Plant & Machinery (cost) 250,000 Motor Vehicle (cost) 80,000
Provision for depreciation of Purchases 360,000
a)Plant & machinery 20,000 Sales 600,000
b)Motor vehicles 6,000 Sales returns 40,000
Purchases returns 20,000 Wages & salaries 60,000
Rent & Rates 15,000 Water & Electricity 8,600
Postage & Telephone 7,500 Bad debts Written off 1,500
Provision for bad debts 1,000 Discount allowed 5,000
Discount received 4,000 Carriage inwards 2,500
Carriage outwards 3,000 Debtors 5,500
Creditors 46,600 Cash at hand 6,600
Cash at bank 30,000
Additional Information
1. Stock on 31st December 2011 was valued at 22,500

2. Depreciation is to be charged at 10% of cost of plant & machinery and 20% of cost of
motor vehicle.
3. Accrued rent (not paid) 3,000
4. Pre-paid rates 1,000
5. Outstanding electricity expense 600
23
Required: using the balances provided
a) Extracted John’s Trial Balance as at 31st December 2011 (2marks)

b) Prepare John’s
(i) Trading Profit & Loss Account for the year ending 31st December 2011 (8marks)
(ii) Balance Sheet as at the last day of the business. (5marks)
1 The following information was obtained from the books of accounts of Mwali Enterprises as
at 30th June 2010.
Capital Kshs. 315,000 Debtors Ksh. 40,000
Stock Kshs. 20,000 Outstanding salaries Kshs.4,500
Drawing Kshs.35,000 Cash Kshs.10,000
Insurance Kshs.11,000 Creditors Kshs.15,000
Rent Kshs.8,000 Prepaid Insurance Kshs.3,500
Premises Kshs.200,00 Land Kshs.56,000
Carriage out Kshs.6,000 Discount received Kshs.5,000
Bank Kshs.20,000 Discount allowed Kshs.4,000
Gross Profit Kshs.75,000
(a) Prepare Mwali enterprises

(i) Profit and loss account (4 marks)
(ii) Balance sheet as at 31st June 2010 (6 marks)
(b) Calculate Mwali Enterprises
(i) Liquidity ratio (2 marks)
(ii) Current ratio (2 marks)
(iii) Comment on the solvency of Mwali Enterprises (1 mark)
24
3.5 Score Board
Range of marks Level of Performance
25-30 Very good
15-24 Good
11-14 Satisfactory
0-10 Read the topic again
3.6 LEARNING OUTCOMES
You have now completed the topic on public finance, please tick in the column which reflect your
understanding of the various learning outcome listed below.
No. Learning Outcome Sure Not Sure
1. I can now prepare a trading account of a business
2. I can now explain and compute the concepts of

depreciation, bad debts, accruals and prepayment
3. I can now prepare a profit and loss account
4. I can now prepare a balance sheet for a business
5. I Can now make a choice on what to invest in
6. I can now determine the viability and performance of

an investment
If you have put a tick at the “not sure” column, please go back and study that section in the topic
before proceeding.
25
If you have ticked “sure” in all the rows in all the columns you are ready for the next topic
Congratulations! You can continue to the next Topic
3.7 FURTHER READING
Deakin B.E. and Maher W.M(1987): Cost Accounting, 2nd Ed. U.S.A.
Ferries R. Kenneth (1993): Financial Accounting and Corporate Reporting, 3rd Ed. Irwin
Mullings G.F and Shao P.S (1979) Mathematics for Management and Finance gage publishers,
Canada
Slater R. and Curwin, J(2002):Quantitative Methods for Business Decisions, 5th Ed. Thomson
26

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Kaimosi Friends University

Directorate of Open Distance and E-Learning

TOPIC THREE: INVESTMENT ANALYSIS

3.1 SPECIFIC LEARNING OUTCOMES

By the end of this topic, you should be able to:

3.2 SECTIONS OF THE TOPIC

These sections are discussed below.

3.2.1 FINAL ACCOUNTS

The Income Statement: The income statement of a firm consists of the

Kamau’s Trading A/c

For the Year ended 31st Dec. 2006.

Opening Stock 5000 Sales 35000

Add Purchases 25000

Cost of good available for sale 30000

Less Closing Stock 6000

Cost of goods sold 24000

Gross Profit c/d 11000 . .

Gross profit b/d 11,000

2. PROFIT AND LOSS ACCOUNT

Give examples of business operating expenses and incomes?

2. To sales, subtract sales returns (returns inwards) to ascertain net sales.

Item Dr (Ksh.) Cr (Ksh.)

Opening stock 3000

Returns inwards 120

Salaries and wages 520

Carriage outwards 110

Discount allowed 150

Additional information: closing stock was valued at Ksh. 550

DEPRECIATION: As seen earlier, all assets except land depreciate or

The annual depreciation = (Cost – Estimated residual value)/estimated life

=(£24,000 – £2000)/5 = £4400.

Cost – Estimated Hours = Hourly depreciation i.e. £24,000 – £2000/10000 =£ 2.20

Using Straight Line Method, depreciation is computed as:

For Year 1: 8000 – 1875 = 6125

Final Accounts Adjustments: Their purpose is to show the true profits

Accruals (Outstanding Expenses): If annual accounts of a business are prepared on 31st

Stock as at 1st Jan 2006 50,000 Land and buildings 240,000

Debtors 90,000 Purchases 280,000

Salaries & Wages 35,000 Fixtures & Fittings 25,000

Sales 520,000 Discount allowed 7,500

Discount received 4,500 Land & Machinery 140,000

Rates 5,600 Advertising 10,400

Insurance 3,800 General expenses 7,200

Provision for bad debts 1,800 Creditors 58,000

Cash in hand 2,400 Bank overdraft 18,600

Drawings 6,000 Capital 300,000

Opening stock 50,000

Add Purchases 280,000

Goods Available for sale 330,000

Less closing stock 60,000

Cost of goods sold 270,000

Gross Profit 250,000

Add discount received 4,500

Salaries & Wages 35,000

Discount allowed 7,500

Add Rates accrued 400 6,000

Less Insur. Pre-paid 500 3,300

General Expenses 7,200

Provision for bad debts 34,200 (1)

Dep. on Plant & mach. 14,000 (2)

Dep. on fixtures & fit. 3,750 (3)

Total expenses 121,350

Net Profit 133,150