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THE COMPLETE GUIDE TO ACCRUAL VS. CASH BASIS ACCOUNTING

THE COMPLETE GUIDE TO ACCRUAL VS. CASH BASIS ACCOUNTING

Why Profitable Businesses Go Broke, How Your Accounting Method Hides (or Reveals) Your True Cash Position, and What Every Business Owner Must Understand About Working Capital

The Profitable Business That Couldn’t Pay Its Bills

Here’s a scenario that destroys businesses every day:

A manufacturing company lands its biggest contract ever—$500,000 over six months. The owner is ecstatic. The income statement shows record revenue. The accountant confirms: “You’re profitable.” The bank account tells a different story.

To fulfill the contract, the company bought $200,000 in materials (paid upfront), hired additional staff (paid every two weeks), and ramped up production (utilities, supplies, overhead—all paid as incurred). The customer? They pay in 60 days. Net-60 terms, standard in the industry.

Two months in, the business is drowning. Revenue is “booked” but cash hasn’t arrived. Expenses are paid in real dollars. The owner stares at financial statements showing profit while the bank account shows near-zero. Payroll is Friday. Suppliers are demanding payment. The “profitable” company is about to collapse.

This isn’t a failure of business strategy. It’s a failure to understand the difference between accrual accounting and cash reality.

The gap between when you “earn” revenue and when you receive cash—and when you “incur” expenses versus when you pay them—is one of the most misunderstood and dangerous concepts in business finance. It’s killed more profitable businesses than bad products ever have.

This guide will ensure you’re not one of them.

PART 1: THE FUNDAMENTAL DIFFERENCE — TWO WAYS TO TELL THE SAME STORY

What Is Cash Basis Accounting?

Cash basis accounting is exactly what it sounds like: you record revenue when cash arrives and expenses when cash leaves.

The rule is simple:

  • Revenue: Recorded when you receive payment
  • Expenses: Recorded when you pay the bill

Example:

  • January 15: You complete a $10,000 project for a client
  • February 28: Client pays you $10,000
  • Cash basis: Revenue is recorded in February (when cash arrived)

Another example:

  • January 1: You receive an invoice for $2,000 in supplies
  • January 31: You pay the invoice
  • Cash basis: Expense is recorded in January (when cash left)

What cash basis shows you: Your actual cash movements. Money in, money out. Simple. Intuitive. Matches your bank statement.

What Is Accrual Basis Accounting?

Accrual basis accounting records revenue when it’s earned and expenses when they’re incurred—regardless of when cash changes hands.

The rule is different:

  • Revenue: Recorded when you’ve completed the work or delivered the product (earned it)
  • Expenses: Recorded when you’ve received the goods or services (incurred the obligation)

Example:

  • January 15: You complete a $10,000 project for a client
  • February 28: Client pays you $10,000
  • Accrual basis: Revenue is recorded in January (when work was completed)

Another example:

  • January 1: You receive an invoice for $2,000 in supplies (supplies already delivered)
  • January 31: You pay the invoice
  • Accrual basis: Expense is recorded in January (when supplies were received), even if you pay later

What accrual basis shows you: The economic reality of your business activity—when value was created or consumed, not when cash moved.

The Core Difference: Timing

Both methods will eventually record the same total revenues and expenses. The difference is timing—when those transactions appear in your books.

Event Cash Basis Records Accrual Basis Records
Complete work for client Nothing yet Revenue (accounts receivable created)
Receive payment from client Revenue Nothing (A/R cleared)
Receive supplies from vendor Nothing yet Expense (accounts payable created)
Pay vendor invoice Expense Nothing (A/P cleared)

This timing difference creates a gap between your accounting “profit” and your actual cash position. That gap is where businesses get into trouble.

PART 2: WHY THIS MATTERS — THE CASH FLOW DISCONNECT

The Accrual Profit Trap

Under accrual accounting, your income statement can show robust profit while your bank account empties. This isn’t accounting magic—it’s the natural result of timing differences.

How this happens:

  1. You deliver products/services → Revenue is recorded immediately
  2. Customer pays in 30-60-90 days → Cash arrives later
  3. You pay suppliers, payroll, rent → Cash leaves immediately
  4. Gap grows → Profit exists on paper, cash crisis exists in reality

The dangerous part: Business owners who don’t understand this look at their P&L, see profit, and assume they’re doing well. They take distributions, make purchases, hire staff—all based on “profit” that hasn’t converted to cash yet.

The Cash Basis Blindspot

Cash basis has the opposite problem. It shows you cash reality but hides upcoming obligations and future revenue.

What cash basis misses:

  1. Receivables: You’ve done $100,000 in work that clients haven’t paid yet. Cash basis shows nothing—that revenue is invisible until payment arrives.
  2. Payables: You owe $50,000 to suppliers. If you haven’t paid yet, cash basis doesn’t show the obligation. Your “cash position” looks better than reality.
  3. Matching: December’s sales might be paid in January. Under cash basis, December looks bad (expenses incurred) and January looks great (revenue arrives)—even though the economic activity happened in December.

The dangerous part: Business owners using cash basis may not see obligations building up or may misunderstand when revenue was actually earned.

The Working Capital Reality

Working capital = Current Assets – Current Liabilities

In simple terms: the money you have available to run day-to-day operations.

Under accrual accounting, working capital includes:

  • Cash (actual money)
  • Accounts Receivable (money owed to you)
  • Inventory (goods you can sell)
  • Minus: Accounts Payable (money you owe)
  • Minus: Short-term debt
  • Minus: Accrued expenses (wages owed, etc.)

The problem: Accounts receivable isn’t cash. You can’t pay rent with an invoice. You can’t make payroll with “money coming in 60 days.”

Working capital management is about understanding the timing of when receivables convert to cash versus when payables come due—and ensuring you don’t run out of cash in between.

PART 3: THE CASH CONVERSION CYCLE — WHERE BUSINESSES GET KILLED

Understanding the Cash Conversion Cycle

The Cash Conversion Cycle (CCC) measures how long it takes for a dollar you spend to come back as a dollar you receive.

The formula:

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payables Outstanding

In plain English:

  • Days Inventory Outstanding (DIO): How long inventory sits before it sells
  • Days Sales Outstanding (DSO): How long customers take to pay you
  • Days Payables Outstanding (DPO): How long you take to pay suppliers

Example:

Metric Days What It Means
Days Inventory Outstanding 45 days Inventory sits for 45 days before selling
Days Sales Outstanding 60 days Customers pay 60 days after sale
Days Payables Outstanding 30 days You pay suppliers in 30 days
Cash Conversion Cycle 75 days You’re “out” the cash for 75 days

What this means: You pay for inventory, wait 45 days to sell it, wait another 60 days to collect—but you had to pay your supplier in 30 days. For 75 days, your cash is tied up in the cycle.

Why the CCC Kills Growing Businesses

Here’s the deadly math:

Stable Business:

  • Revenue: $100,000/month
  • Cash conversion cycle: 60 days
  • Cash tied up in cycle: ~$200,000 (2 months of working capital needed)
  • If you have $200,000 working capital: You’re fine

Growing Business:

  • Revenue grows from $100,000 to $150,000/month
  • Cash conversion cycle: Still 60 days
  • Cash tied up in cycle: Now ~$300,000 needed
  • If you still have $200,000 working capital: $100,000 shortfall

The paradox: Growth requires MORE working capital, not less. The faster you grow, the more cash gets tied up in receivables and inventory. Growth can literally bankrupt a profitable business.

This is why investors and lenders always ask: “How will you finance your growth?” They understand that growth consumes cash before it generates cash.

PART 4: ACCRUAL VS. CASH — IMPACT ON KEY FINANCIAL METRICS

How Each Method Affects Your Financial Statements

Income Statement (Profit & Loss)

Scenario Cash Basis Shows Accrual Basis Shows
Big sale completed, not yet paid No revenue Revenue recorded
Received payment for old work Revenue spike No change (already recorded)
Bought inventory, not yet paid No expense Expense recorded
Paid old supplier invoice Expense spike No change (already recorded)
Prepaid 12 months of insurance Full expense now 1/12 expense per month
Received deposit for future work Revenue now Deferred revenue (liability)

Balance Sheet

Item Cash Basis Accrual Basis
Accounts Receivable Doesn’t exist Tracks all money owed to you
Accounts Payable Doesn’t exist Tracks all money you owe
Inventory May not track Tracked as asset
Prepaid Expenses Doesn’t exist Asset until consumed
Deferred Revenue Doesn’t exist Liability until earned

Cash Flow Statement

Under cash basis, the cash flow statement is essentially the same as your income statement. Under accrual basis, the cash flow statement reconciles accrual profit to actual cash movement—and this reconciliation reveals critical insights.

The Reconciliation: From Accrual Profit to Cash Flow

This is one of the most important financial analyses you can understand:

Net Income (Accrual Basis)
+ Depreciation/Amortization (non-cash expense)
- Increase in Accounts Receivable (sold but didn't collect)
+ Decrease in Accounts Receivable (collected old sales)
- Increase in Inventory (bought more than sold)
+ Decrease in Inventory (sold more than bought)
+ Increase in Accounts Payable (incurred but didn't pay)
- Decrease in Accounts Payable (paid old bills)
+ Increase in Accrued Expenses (owe more)
- Decrease in Accrued Expenses (paid down)
= Cash Flow from Operations

What this tells you:

  • Receivables increasing: You’re “profitable” but not collecting cash
  • Inventory increasing: You’re buying faster than selling
  • Payables increasing: You’re stretching payments (may be good or bad)
  • Payables decreasing: You’re paying down—cash outflow

Real example:

Item Amount
Net Income $100,000
Depreciation +$20,000
A/R Increased -$50,000
Inventory Increased -$30,000
A/P Increased +$15,000
Cash Flow from Operations $55,000

Despite $100,000 in profit, only $55,000 in actual cash was generated. The rest is tied up in receivables and inventory.

PART 5: THE DANGEROUS SCENARIOS — WHERE BUSINESSES FAIL

Scenario 1: The Growing Company Cash Crunch

The setup:

  • Service company billing $200,000/month
  • Net profit margin: 20% ($40,000/month profit)
  • Customers pay in 45 days on average
  • All expenses paid within 30 days

The growth:

  • Wins major contract: Revenue jumps to $350,000/month
  • Still 20% margin ($70,000/month profit)
  • Still 45-day collections

The math:

Before growth:

  • Receivables (45 days of sales): ~$300,000
  • Monthly cash needs: $160,000 (expenses)
  • Working capital required: ~$300,000

After growth:

  • Receivables (45 days of sales): ~$525,000
  • Monthly cash needs: $280,000 (expenses)
  • Working capital required: ~$525,000
  • Additional working capital needed: $225,000

The crisis: The company needs $225,000 more in working capital to support growth. That “extra” profit of $30,000/month won’t cover it—it would take 7+ months of accumulated profits to fund the growth, assuming no distributions and perfect timing.

What happens: Without additional financing, the company can’t make payroll or pay vendors while waiting for the larger receivables to convert to cash. Profitable on paper, bankrupt in reality.

Scenario 2: The Seasonal Business Trap

The setup:

  • Retail business: 40% of annual revenue in November-December
  • Annual revenue: $1,000,000
  • Uses accrual accounting

The pattern:

Period Revenue Cash Received Inventory Bought Cash Paid
Sep-Oct $100,000 $80,000 $300,000 $250,000
Nov-Dec $400,000 $200,000 $50,000 $100,000
Jan-Feb $100,000 $350,000 $50,000 $50,000

The trap:

  • September-October: Buying inventory for holiday season. Cash going OUT.
  • November-December: Selling like crazy, but on credit cards that take time to settle, or to businesses that pay in 30 days. Revenue recorded, cash still coming.
  • January-February: Collections arrive, but revenue drops. Looks like terrible performance.

Accrual accounting shows: Strong Q4, decent Q1. Cash reality: Massive cash outflow in Q3, cash doesn’t arrive until Q1.

The business needs financing to bridge the gap between buying inventory and collecting sales—even though it’s “profitable.”

Scenario 3: The Invoice Timing Game

The setup:

  • Consulting company, cash basis accounting
  • Major project completed December 15
  • Invoice sent: $150,000
  • Client pays: January 10

The problem:

  • December: No revenue recorded (cash basis—payment not received)
  • January: $150,000 revenue recorded (cash arrived)

What this hides:

  • December looks like a terrible month (expenses but no revenue)
  • January looks like a great month (windfall!)
  • The actual economic activity (the work) happened in December
  • Performance analysis is distorted

For tax purposes: This might be beneficial (defer revenue to next year), but for understanding your actual business performance, it’s misleading.

Scenario 4: The Prepayment Distortion

The setup:

  • Business pays annual insurance premium: $24,000 on January 1
  • Uses cash basis accounting

Cash basis result:

  • January: $24,000 expense
  • February-December: $0 insurance expense

What this does:

  • January looks unprofitable (huge expense)
  • Other months look artificially better
  • Monthly profit analysis is meaningless
  • Year-over-year January comparisons are distorted

Accrual basis result:

  • January: $2,000 expense (1/12 of annual premium)
  • February-December: $2,000/month each
  • $22,000 sits as “prepaid expense” asset, consumed monthly

Accrual gives you accurate monthly performance; cash basis distorts it.

PART 6: WHICH METHOD SHOULD YOUR BUSINESS USE?

When Cash Basis Makes Sense

Cash basis may be appropriate when:

✓ Small, simple business — Sole proprietor, few transactions, no inventory

✓ Service business with immediate payment — Customers pay at time of service (retail, restaurants, cash-based services)

✓ No significant receivables or payables — Cash in ≈ Revenue earned; Cash out ≈ Expenses incurred

✓ IRS requirement is met — Generally, businesses with under $25-27 million in average annual gross receipts can use cash basis

✓ Simplicity is priority — Less accounting complexity, easier bookkeeping

✓ Tax timing benefits — Some businesses prefer cash basis for tax deferral opportunities

Cash basis works well for:

  • Freelancers and consultants (paid on completion)
  • Small retail (immediate payment)
  • Personal service providers
  • Small professional practices

When Accrual Basis Is Necessary

Accrual basis is required or strongly recommended when:

✓ Inventory-based business — IRS generally requires accrual for businesses with inventory

✓ Revenue over $25-27 million — IRS requires accrual above this threshold

✓ Significant receivables — B2B businesses where customers pay on terms

✓ Complex operations — Multiple revenue streams, long-term contracts, deposits received

✓ Seeking financing — Banks and investors typically require accrual-basis financials

✓ Want accurate performance measurement — Matching revenue with the expenses incurred to generate it

✓ GAAP compliance required — For audited financials, public companies, or certain contracts

Accrual basis is necessary for:

  • Manufacturing companies
  • Wholesalers and distributors
  • B2B service companies with payment terms
  • Construction companies (especially with long-term contracts)
  • Any business seeking bank loans or investment
  • Companies with inventory

The Hybrid Approach: Managing Both

Many businesses maintain both:

  1. Accrual books — For accurate business management, financial analysis, and lender requirements
  2. Cash basis conversion — For tax filing (if eligible) and cash planning

This gives you:

  • Accurate understanding of economic performance (accrual)
  • Tax optimization opportunities (cash basis if allowed)
  • Cash flow visibility (cash-based analysis)

Your accountant can maintain accrual records and prepare cash-basis tax returns by making adjustments at year-end. This is common and perfectly legal.

PART 7: WORKING CAPITAL MANAGEMENT — PRACTICAL STRATEGIES

Understanding Your Working Capital Needs

Calculate your baseline working capital requirement:

  1. Identify your cash conversion cycle
    • How long does inventory sit?
    • How long do customers take to pay?
    • How long can you delay paying suppliers?
  2. Calculate cash tied up in the cycle
    • Average daily operating expenses × Cash conversion cycle days
    • Example: $10,000/day × 60-day cycle = $600,000 working capital needed
  3. Add safety buffer
    • Unexpected delays happen
    • Add 20-30% cushion

Strategies to Improve Working Capital

Reduce Days Sales Outstanding (collect faster):

  • Invoice immediately upon delivery/completion
  • Offer early payment discounts (e.g., 2% if paid within 10 days)
  • Require deposits or progress payments
  • Accept credit cards (faster settlement than invoicing)
  • Send payment reminders before due dates
  • Have clear, enforced collection policies
  • Consider factoring for problematic receivables

Reduce Days Inventory Outstanding (turn faster):

  • Improve demand forecasting
  • Use just-in-time inventory practices
  • Identify and liquidate slow-moving stock
  • Negotiate consignment arrangements with suppliers
  • Review SKU profitability—eliminate low-turn items

Increase Days Payables Outstanding (pay strategically):

  • Negotiate longer payment terms with suppliers
  • Use the full payment term (don’t pay early unless there’s a discount)
  • Prioritize vendor relationships that offer better terms
  • Consider supply chain financing programs

But be careful: Stretching payables too far damages supplier relationships and may result in worse terms, supply interruptions, or lost discounts.

The Cash Flow Forecast

Every business should maintain a rolling 13-week cash flow forecast:

Week Beginning Cash Cash In Cash Out Ending Cash
Week 1 $50,000 $30,000 $35,000 $45,000
Week 2 $45,000 $25,000 $40,000 $30,000
Week 3 $30,000 $45,000 $35,000 $40,000
… … … … …

What to include:

Cash In:

  • Customer payments (based on actual receivables aging)
  • Other income (interest, asset sales, etc.)
  • Loan proceeds (if expected)

Cash Out:

  • Payroll and payroll taxes
  • Rent/lease payments
  • Supplier payments (based on actual payables)
  • Loan payments
  • Tax payments
  • Insurance premiums
  • Utilities
  • All other regular payments

The insight: You’ll see cash crunches coming weeks in advance, giving you time to arrange financing, accelerate collections, or delay expenses.

PART 8: HOW LENDERS VIEW YOUR FINANCIALS

What Banks Want to See

Banks and lenders almost always require accrual-basis financial statements.

Why? Because accrual accounting shows:

  • True receivables (money you’re owed)
  • True payables (money you owe)
  • Accurate revenue matching (when value was created)
  • Working capital position
  • The full balance sheet picture

Cash basis statements hide too much. A company could have $500,000 in uncollected receivables that don’t appear on cash-basis statements—those are assets the bank wants to know about (and potentially lend against).

Key Ratios Lenders Calculate

From your accrual financial statements, lenders analyze:

Liquidity Ratios:

  • Current Ratio = Current Assets ÷ Current Liabilities
    • Measures ability to pay short-term obligations
    • Lenders want to see 1.2 or higher
  • Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities
    • More conservative—excludes inventory
    • Lenders want 1.0 or higher

Leverage Ratios:

  • Debt-to-Equity = Total Liabilities ÷ Equity
    • How leveraged is the business?
    • Lower is generally better

Coverage Ratios:

  • Debt Service Coverage Ratio = (Net Income + Depreciation + Interest) ÷ (Principal + Interest Payments)
    • Can you afford loan payments?
    • Lenders want 1.25 or higher

Efficiency Ratios:

  • Receivables Turnover = Revenue ÷ Average Receivables
    • How quickly do you collect?
  • Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
    • How quickly does inventory sell?

All of these require accrual-basis accounting to calculate accurately.

The Quality of Earnings Analysis

Sophisticated lenders and investors perform quality of earnings analysis, which includes:

  1. Analyzing receivables aging — Are receivables actually collectible, or is there a lot of old, doubtful stuff?
  2. Revenue recognition review — Is revenue being recognized appropriately, or is it aggressive/premature?
  3. Accrual analysis — Are accruals reasonable, or is the company manipulating timing?
  4. Working capital normalization — What’s the true ongoing working capital need?
  5. Cash flow reconciliation — Does accrual profit convert to actual cash?

The bottom line: If you want financing, you need clean, accrual-basis financials that can withstand scrutiny.

PART 9: TAX IMPLICATIONS — ACCRUAL VS. CASH

IRS Rules on Accounting Methods

Who can use cash basis:

  • Businesses with average annual gross receipts of $25-27 million or less (threshold adjusts for inflation)
  • Certain businesses regardless of size (farms, qualified personal service corporations)
  • Businesses without inventory (with some exceptions)

Who must use accrual:

  • Businesses above the gross receipts threshold
  • C corporations (with exceptions for small businesses)
  • Tax shelters
  • Certain businesses with inventory (though rules have relaxed for small businesses)

Tax Planning with Accounting Methods

Cash basis tax advantages:

  1. Defer revenue: Complete work in December, don’t bill until January—revenue deferred to next year
  2. Accelerate deductions: Pay expenses in December instead of January—deduction in current year
  3. Prepay expenses: Pay January rent in December—deduction in current year (limited for certain items)

Accrual basis considerations:

  1. Revenue recognized when earned: Even if not collected, may owe tax
  2. Deductions when incurred: Even if not paid, can deduct
  3. Less timing flexibility: Fewer opportunities to shift income between years

The All Events Test (Accrual)

Under accrual accounting for tax purposes, revenue is recognized when:

  1. All events have occurred that fix the right to receive payment
  2. The amount can be determined with reasonable accuracy

Expenses are deductible when:

  1. All events have occurred that establish the liability
  2. The amount can be determined with reasonable accuracy
  3. Economic performance has occurred

This means: You might owe tax on revenue you haven’t collected yet. This can create cash crunches at tax time.

Changing Accounting Methods

You can change accounting methods, but:

  • Requires IRS approval (Form 3115)
  • May require adjustment for items that would be duplicated or omitted
  • “Section 481(a) adjustment” may spread tax impact over multiple years
  • Should be done with professional guidance

PART 10: COMMON MISTAKES AND MISCONCEPTIONS

Mistake #1: Confusing Profit with Cash

The error: “My P&L shows $200,000 profit, so I should have $200,000 more in the bank.”

The reality: Profit and cash are different things. Profit includes non-cash items (depreciation), timing differences (receivables/payables), and doesn’t account for capital expenditures, loan payments, or owner distributions.

The fix: Always analyze your cash flow statement alongside your income statement. Understand where profit converts to cash—and where it doesn’t.

Mistake #2: Not Forecasting Cash Under Accrual

The error: Using accrual accounting for financials but not separately tracking cash.

The reality: Accrual financials don’t tell you if you can make payroll next week.

The fix: Maintain a rolling cash flow forecast. Know your receivables aging. Track your payables timing. Understand when cash will actually move.

Mistake #3: Ignoring Working Capital in Growth Plans

The error: Planning growth without accounting for the additional working capital required.

The reality: Growth consumes cash before it generates cash. A 50% revenue increase might require 50% more working capital—immediately.

The fix: Before pursuing growth, calculate your working capital requirement at the new revenue level. Secure financing BEFORE you need it.

Mistake #4: Managing by Cash Basis When You Need Accrual Insights

The error: Small business grows but continues using cash-basis thinking.

The reality: As businesses add inventory, receivables, and complexity, cash basis hides critical information.

The fix: Even if you file taxes on cash basis, maintain internal accrual records for management decisions. Know your true receivables and payables position.

Mistake #5: Aggressive Revenue Recognition

The error: Recording revenue before it’s truly earned (accrual) or before work is complete.

The reality: This inflates current-period profit but creates future problems—and may violate GAAP or tax rules.

The fix: Be conservative with revenue recognition. Recognize revenue when earned, not before. If in doubt, defer.

Mistake #6: Not Matching Expenses to Revenue

The error: Recording revenue in one period and related expenses in another.

The reality: Profit margins become meaningless when revenues and related costs are in different periods.

The fix: Under accrual, match expenses to the revenue they help generate. This gives you accurate margin analysis.

PART 11: PRACTICAL TOOLS AND FRAMEWORKS

The Weekly Cash Position Report

Every business owner should review this weekly:

WEEKLY CASH POSITION REPORT

Beginning Cash Balance:               $__________

+ Expected Collections This Week:     $__________
  (From A/R aging - what's actually due this week)

+ Other Cash In:                      $__________

= Total Cash Available:               $__________

- Payroll & Payroll Taxes:            $__________
- Accounts Payable Due:               $__________
- Loan Payments:                      $__________
- Rent/Lease:                         $__________
- Other Fixed Payments:               $__________
- Discretionary Payments:             $__________

= Ending Cash Balance:                $__________

Minimum Cash Needed:                  $__________
Surplus/(Shortfall):                  $__________

The 13-Week Cash Flow Template

Week 1 2 3 4 5 6 7 8 9 10 11 12 13
Beginning Cash
Cash In:
A/R Collections
Cash Sales
Other
Total Cash In
Cash Out:
Payroll
Rent
Suppliers
Utilities
Loan Payments
Taxes
Other
Total Cash Out
Net Cash Flow
Ending Cash

Receivables Aging Analysis

Review weekly:

Customer Total Owed Current 1-30 Days 31-60 Days 61-90 Days 90+ Days
Customer A $25,000 $10,000 $15,000 $0 $0 $0
Customer B $18,000 $0 $8,000 $10,000 $0 $0
Customer C $12,000 $0 $0 $0 $7,000 $5,000
Total $55,000 $10,000 $23,000 $10,000 $7,000 $5,000

Action triggers:

  • 31-60 days: Follow-up call/email
  • 61-90 days: Escalate, payment plan discussion
  • 90+ days: Collections action, consider write-off

Working Capital Calculation

Monthly calculation:

WORKING CAPITAL ANALYSIS

Current Assets:
  Cash                        $__________
  Accounts Receivable         $__________
  Inventory                   $__________
  Prepaid Expenses            $__________
  Total Current Assets:       $__________

Current Liabilities:
  Accounts Payable            $__________
  Accrued Expenses            $__________
  Short-term Debt             $__________
  Current Portion Long-term   $__________
  Total Current Liabilities:  $__________

Working Capital:              $__________

Current Ratio:                __________ (Target: >1.2)
Quick Ratio:                  __________ (Target: >1.0)

PART 12: FREQUENTLY ASKED QUESTIONS

Q: Can I use cash basis for my internal management and accrual for the bank?

A: Yes, but it’s backward. Most businesses should use accrual internally (for better management insights) and may convert to cash for tax purposes if eligible. Maintaining two complete sets isn’t practical, but your accountant can make year-end adjustments to convert accrual records to cash-basis tax returns.

Q: My business is profitable but I’m always short on cash. What’s happening?

A: This is the classic accrual-cash disconnect. Common causes:

  • Receivables growing faster than collections
  • Inventory increasing
  • Paying down debt (principal payments aren’t expenses)
  • Capital expenditures (not on P&L)
  • Owner distributions
  • Growth consuming working capital

Analyze your cash flow statement to see where profit isn’t converting to cash.

Q: Should I offer early payment discounts to customers?

A: Calculate the cost. A 2% discount for payment in 10 days instead of 30 days equals 36% annualized (2% × 360/20 days early). That’s expensive. However, if you’re using expensive financing (like factoring or MCA) to cover the wait, the discount might be cheaper. Also consider the reduction in collection effort and bad debt risk.

Q: How do I explain to my bank why my cash flow doesn’t match my profit?

A: Banks expect this—they understand accrual accounting. Provide:

  • Cash flow statement showing the reconciliation
  • Receivables aging (proving receivables are collectible)
  • Explanation of any large timing differences
  • Working capital analysis

A good banker will appreciate your understanding of the difference.

Q: My accountant uses accrual, but I don’t understand the financial statements. Help?

A: Focus on three things:

  1. Income Statement: Did you make or lose money? (Economic activity)
  2. Cash Flow Statement: Did cash go up or down? Why? (Actual cash)
  3. Balance Sheet: What do you own, what do you owe, and what’s left? (Net position)

The cash flow statement is the bridge between income statement profit and actual bank account movement.

Q: Is it legal to switch from accrual to cash basis (or vice versa)?

A: Yes, with IRS approval. You’ll need to file Form 3115 and may have a “Section 481(a) adjustment” to prevent items from being counted twice or not at all. This should be done with a tax professional—the rules are complex.

Q: How do I handle deposits from customers under each method?

A:

  • Cash basis: Customer deposit is revenue when received
  • Accrual basis: Customer deposit is a liability (“deferred revenue”) until you earn it by delivering goods/services

The accrual treatment is more accurate—you haven’t earned the revenue yet, so it shouldn’t be on your income statement. You owe the customer something.

Q: What’s the biggest mistake business owners make with working capital?

A: Treating receivables like cash. “I have $200,000 in receivables” doesn’t mean you have $200,000 to spend. Until it’s collected, it’s a promise, not cash. Many businesses overextend based on receivables that take longer to collect than expected—or never collect at all.

CONCLUSION: CASH IS OXYGEN — PROFIT IS FOOD

Here’s the metaphor that captures the essence of this guide:

Profit is food. Cash is oxygen.

You can survive weeks without food. You cannot survive minutes without oxygen.

A business can survive periods of low profit. It cannot survive running out of cash.

Accrual accounting tells you how well you’re eating—are you generating value, earning more than you spend, building a sustainable enterprise? It’s essential for understanding your economic performance.

Cash management tells you if you can breathe—can you pay bills today, make payroll Friday, cover the rent check? It’s essential for survival.

The businesses that thrive understand both:

  • They use accrual accounting to measure true performance
  • They maintain rigorous cash forecasting to ensure liquidity
  • They understand that growth consumes working capital
  • They arrange financing BEFORE cash crunches hit
  • They know that a profitable company can still fail—if it runs out of cash

Your action items:

  1. Know your accounting method and understand its implications
  2. Maintain a 13-week cash flow forecast regardless of accounting method
  3. Monitor receivables aging weekly
  4. Calculate your working capital need and maintain adequate cushion
  5. Understand your cash conversion cycle and work to improve it
  6. Before pursuing growth, calculate the working capital required
  7. Reconcile profit to cash regularly—understand where they diverge

The difference between accrual and cash isn’t academic. It’s the difference between understanding your business and being blindsided by it. It’s the difference between strategic growth and accidental bankruptcy.

Now you understand it. Use that understanding to build a business that’s not just profitable—but actually has the cash to prove it.

SOURCES AND FURTHER READING

  • Financial Accounting Standards Board (FASB): Revenue Recognition Standards https://www.fasb.org/
  • IRS: Accounting Periods and Methods (Publication 538) https://www.irs.gov/publications/p538
  • AICPA: Cash vs. Accrual Accounting Resources https://www.aicpa.org/
  • U.S. Small Business Administration: Managing Business Finances https://www.sba.gov/business-guide/manage-your-business/manage-your-finances
  • SCORE: Financial Management Resources https://www.score.org/

This guide is for educational purposes and does not constitute accounting, tax, or financial advice. Accounting method selection has tax and business implications specific to your situation. Consult with qualified accounting and tax professionals for advice specific to your circumstances.

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