Your business sells products both at retail to consumers and to other businesses. You extend short-term credit to your business customers. Over the years, you have invested in various long-term operating assets (called fixed assets) that you need to conduct the activities of the business: land and a building, computers, trucks, office furniture, cash registers, and so on. Your business borrows money from two banks. Yours is not the only business model in the world of course. But it’s a good comprehensive model to look at; one that captures most cash flow factors. Read on…


Here’s a rundown on the items reported in your balance sheet, paying particular attention to cash flow aspects:

Cash: This item includes cash on hand (coins and currency) and money on deposit in checking accounts. Sooner or later, every transaction goes through the cash account, and it’s the sooner or later that you should understand.

Accounts receivable: You extend credit to your business customers; this asset account holds the amount of customers’ receivables that should be collected in the near term. The balance of this account is the amount of money not yet collected from customers. It’s been recorded as sales revenue, but it hasn’t been received in cash as of the balance sheet date.

Inventory: You stockpile products and hold them for sale and make immediate delivery to customers when sold; this asset account holds the cost of goods not yet sold, but that should be sold in the near term. The balance is your inventory asset account is the cost value of products held for sale. This amount has not been recorded as expense yet.

Prepaid Expenses: You prepay some expenses, such as insurance, property taxes, a store of office and shipping supplies, and so on. This asset account holds the cost of these prepaid costs that will not be charged to expense until time passes. You’ve paid cash for these things, but their cost hasn’t yet been recorded to expense.

Property, Plant, and Equipment (fixed assets): The balance in this account is the cost of long-term operating resources your business has bought. Acquiring these assets required major cash outlays, most of which occurred in previous years.

Accumulated depreciation: This contra account is deducted from the original cost of your property, plant, and equipment asset account; the recording of depreciation expense each year increases the balance in this account, thus decreasing the book value of your fixed assets. Recording depreciation expense doesn’t involve a cash outlay. The cash outlay was made when the fixed assets were bought.

Accounts payable: You purchase products for inventory and buy many things on credit, which means that their costs aren’t paid immediately. This liability account holds the total cost of these credit purchases until the amounts are paid. No cash has been paid out yet for these purchases. Of course, that’s why they’re a liability at the end of the year.

Accrued expenses payable: Before being paid, certain expenses are recorded based on calculations and estimates of costs as they accrue, or accumulate, during the period. Examples include accrued vacation pay, property taxes to be paid later, and accrued interest on notes payable. This liability account holds the costs of the expenses until they’re paid. Like accounts payable, no cash has been paid out yet for these liabilities.

Notes payable: The amount of money borrowed from your banks is reported in this liability account. Actually, the total amount borrowed is divided into the current (short-term) portion, and the remainder is put in the long-term category (see Figure 3-3). Debt is a major source of money to most businesses.

Owner’s equity—invested capital: The amount of money invested in the business by its owners is recorded in this account. The exact title of the account depends on how the business entity is organized legally. For example, a business corporation issues capital stock shares to its owners, so the account is called capital stock. Owners’ equity is a major source of money to a business.

Owner’s equity—retained earnings: The amount of annual profit earned by a business is recorded in this account to recognize the increase in owners’ equity and to separate this source of owners’ equity from money invested in the business by the owners. The balance in this account equals the cumulative total of annual profits over the years, minus any annual losses that occurred, and minus distributions to owners from profit.

The financial sustainability of a business depends foremost on its ability to generate a steady stream of cash flow from profit. Without a doubt, you should have a good grip on the factors that drive cash flow from profit. Profit is the mainstream of cash for every business. You should be very clear on the factors that control cash flow from profit. Financial and investment analysts pay a great deal attention to cash flow from profit, for good reason.  Generally, the big three factors governing cash flow from profit are changes in accounts receivable and inventory and depreciation. Changes in accounts payable and other short-term operating liabilities are important factors in some situations — but first look to the big three factors.