Capital (Contd.) – Working Capital and Profit

 

SS2 Commerce Class Note

Term: Third Term Week: 6 Topic: Capital (Contd.) – Working Capital and Profit

1. Importance of Working Capital

Working capital is the capital of a business that is used in its day-to-day trading operations (calculated as Current Assets minus Current Liabilities). Its importance to a business cannot be overstated:

• Day-to-Day Operations: It ensures there is enough cash on hand to run the daily operations of the business, such as purchasing raw materials and paying for transport.
• Payment of Short-Term Debts: It allows the business to pay its short-term obligations (like electricity bills and supplier invoices) as they fall due.
• Payment of Wages: It guarantees that employees and workers can be paid their salaries and wages on time.
• Takes Advantage of Cash Discounts: A business with good working capital can pay suppliers quickly, allowing them to negotiate and enjoy cash discounts.
• Provides a Buffer against Shocks: It helps the business survive temporary financial crises or unexpected downturns in sales.

2. Meaning of Profit

In commerce, profit is the financial reward that a business owner receives for taking the risk of investing capital into a business enterprise. It is the financial gain achieved when the total revenue earned from selling goods or services exceeds the total costs and expenses incurred in operating the business.

3. Accountant's View vs. Economist's View of Profit

There is a distinct difference in how accountants and economists calculate profit:

• Accountant’s View of Profit: The accountant looks only at the actual money that leaves the business (explicit costs). Accounting profit is simply the total revenue minus the measurable, out-of-pocket costs of running the business (e.g., rent, wages, materials).
  • Formula: Total Revenue - Explicit Costs.
• Economist’s View of Profit: The economist looks at both explicit costs and implicit costs (also known as opportunity costs). An implicit cost is what the business owner gave up to run the business (for example, the salary they could have earned if they worked for someone else, or the rent they could have collected if they leased their building instead of using it).
  • Formula: Total Revenue - (Explicit Costs + Implicit Costs).
  • Note: Economic profit is always lower than accounting profit.

4. Differentiating Between Gross Profit and Net Profit

To understand a business's true financial position, it is important to differentiate between gross and net profit:

• Gross Profit: This is the profit made from the buying and selling of goods before any running expenses (overheads) are deducted. It is the difference between the sales revenue and the direct cost of purchasing or producing the goods sold (Cost of Goods Sold).
  • Formula: Gross Profit = Sales - Cost of Goods Sold.
• Net Profit: This is the actual "bottom line" or final profit of the business. It is arrived at after all operating expenses (like rent, electricity, salaries, advertising, etc.) have been deducted from the Gross Profit.
  • Formula: Net Profit = Gross Profit - Total Operating Expenses.

5. Mathematical Formulas for Solving Questions

Students must be able to use the following formulas to solve basic business calculations:

• Working Capital = Current Assets – Current Liabilities
• Cost of Goods Sold (COGS) = Opening Stock + Purchases - Closing Stock
• Gross Profit = Net Sales – Cost of Goods Sold
• Net Profit = Gross Profit – Operating Expenses