Prepare and interpret the income statement and balance sheet for a sole trader.

Prepare an income statement to measure profit and a balance sheet to show financial position, and see how the two reports connect.

Generated by Claude Opus 4.77 min answerUpdated 2026-05-29

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking

A business prepares financial statements to report its performance and position to the owner and other users. The two core reports for a sole trader are the income statement and the balance sheet. A cash flow statement is also commonly prepared, but the income statement and balance sheet are the focus here.

The income statement (statement of financial performance)

The income statement measures profit for a period (for example, a year). It applies the matching principle: revenue earned in the period is matched against the expenses incurred in earning it.

Net\ Profit = Revenue - Expenses

For a trading business that buys and sells goods, an extra step calculates gross profit first:

Gross\ Profit = Sales - Cost\ of\ Goods\ Sold

Net\ Profit = Gross\ Profit - Operating\ Expenses

Cost of goods sold itself is found as:

COGS = Opening\ Inventory + Purchases - Closing\ Inventory

The balance sheet (statement of financial position)

The balance sheet lists what the business owns and owes at one date. It is a direct presentation of the accounting equation, $Assets = Liabilities + Owner's\ Equity$ . Items are classified to make the report more useful:

Current assets: expected to be used or converted to cash within twelve months (cash, debtors, inventory).
Non-current assets: held longer than twelve months (equipment, vehicles, premises).
Current liabilities: due within twelve months (creditors, bank overdraft).
Non-current liabilities: due after twelve months (long-term loan).
Owner's equity: opening capital plus net profit, less drawings.

How the statements connect

The two reports are linked through owner's equity. Net profit calculated in the income statement is added to the owner's capital, and drawings are subtracted, to give the closing equity shown on the balance sheet:

Closing\ Capital = Opening\ Capital + Net\ Profit - Drawings

Worked example

Building both statements

Given information

For the year ended 30 June: Sales $120\,000$ ; Cost of goods sold $70\,000$ ; Operating expenses $30\,000$ . Opening capital $50\,000$ ; Drawings $12\,000$ . At year end: Cash $18\,000$ , Inventory $22\,000$ , Equipment $40\,000$ , Creditors $12\,000$ .

Income statement

Gross profit $= 120\,000 - 70\,000 = 50\,000$
Net profit $= 50\,000 - 30\,000 = 20\,000$

Closing capital

Closing capital $= 50\,000 + 20\,000 - 12\,000 = 58\,000$

Balance sheet check

Total assets $= 18\,000 + 22\,000 + 40\,000 = 80\,000$
Liabilities + equity $= 12\,000 + 58\,000 = 70\,000$

These do not match, so a recording problem exists somewhere (for instance, an asset or liability has been omitted). The check itself shows the power of the equation: the balance sheet must balance, and when it does not, you know to investigate before finalising.

Why this matters

Owners use the income statement to judge whether the business is profitable and the balance sheet to judge whether it is solvent and well financed. Being able to prepare both, and explain how profit feeds into equity, is central to financial accounting assessment.