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Need/Importance and Purpose of Trading Account

The purpose and importance of preparing trading account is summarised as under : 

1. Ascertaining gross profit/gross loss. The main purpose of preparing Trading account is to ascertain gross profit or gross loss. Excess of credit side over the debit side of Trading account is gross profit and the excess of debit side over the credit side is gross loss. The gross profit ratio between 20% to 30% is treated as standard. Gross profit should be sufficient to cover selling and distribution expenses. The adequacy of gross profit is measured with reference to sales.

2. Ascertaining ratio of direct expenses to gross profit. Trading account shows the details of direct expenses incurred in acquiring and manufacturing goods. Cost of production increases with the increase in direct expenses. The margin and the amount of profit is vitally affected by direct expenses. The ratio of direct expenses to gross profit is calculated and compared with the desired and previous performance and efficiency is measured. 

3. Ascertaining ratio between purchases and direct expenses. Relationship between purchases and direct expenses is ascertained through Trading account. The amount of purchases and direct expenses are available from Trading account. Direct expenses add to the cost of purchases. The relationship between purchases and direct expenses indicates how far direct expenses are reasonable and adequate.

4. Calculation of cost of goods sold. Gross profit or loss is based upon cost of goods sold. It is based upon the information available from Trading account. Cost of goods sold is ascertained by adding opening stock, purchases and direct expenses and deducting closing stock from it. It can also be calculated by deducting gross profit from sales. Cost of goods sold helps us in calculating profit of the firm.

5. Calculation of gross profit ratio. The firm calculates gross profit ratio and measures the efficiency of its performance. Gross profit ratio is calculated by comparing gross profit to net sales. Gross profit ratio should be sufficient to cover expenses. The ratio is compared with the desired ratio or with the ratio of previous year and performance evaluated.