First, the key terms.

Receivable
An amount owed by a customer.
Accrual accounting
Recording economic activity under recognition rules rather than only when cash moves.
Equity
The residual accounting interest after liabilities are subtracted from assets.

The idea, explained

Accrual accounting can recognize revenue before cash arrives and expenses before or after cash leaves. Assets equal liabilities plus equity under the accounting identity. Operating, investing and financing cash flows describe different sources and uses of money. Reading the statements together helps distinguish a growing business from one temporarily supported by borrowing or asset sales. Notes and accounting policies explain details that headline totals can hide.

STEP 1

Read the snapshots and flows

The balance sheet is dated at a point in time. The income and cash-flow statements cover a period. Compare like periods and read the notes, because identical headline numbers can arise from different accounting choices and transactions.

STEP 2

Track an unpaid sale

A company can recognize revenue and a receivable before the customer pays, if the applicable recognition criteria are met. It can therefore show income without the corresponding cash receipt. Collecting the receivable later changes asset composition rather than creating the same revenue a second time.

STEP 3

Check where cash came from

Borrowing and selling equipment can raise cash without indicating healthy recurring operations. Separate operating, investing and financing flows. Read the statements together to understand both performance and the resources available to meet obligations.

Follow a worked example.

A fictional company completes $1,000 of work on credit, incurring $700 of expenses paid in cash. It may record $300 of accounting profit but have negative operating cash flow until the customer pays.

Walk it through, one step at a time

  1. A fictional firm completes a $1,000 credit sale and pays $600 of related expenses in cash. Ignore taxes and other transactions.
  2. It records $400 of profit in this simplified example, but the sale has not yet brought in cash. Operating cash movement is negative $600.
  3. When the customer pays $1,000, cash rises and receivables fall. Do not count the collection as another $1,000 of revenue.

Where people get stuck

Profit, cash generation and the bank balance are related but are not interchangeable measures.

Now try it yourself.

Pause before opening each answer. Explain your reasoning in your own words.

1. Check the core idea

Can a profitable company run short of cash?

Reveal the answer & reasoning

Yes. Customers may pay late, inventory may tie up funds and debt payments may consume cash even when reported income is positive.

2. Apply what you learned

Why might increasing sales coincide with a cash shortage?

Reveal the answer & reasoning

More sales on credit can increase receivables before collection, while wages, suppliers and inventory require earlier cash payments. Growth can increase the need for working capital.