How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

Chapter 6. INVENTORY AND ACCOUNTS PAYABLE

Acquiring Inventory on the Cuff

Please refer to Exhibit 6.1 at the start of the chapter. This chapter focuses on the connection between the inventory asset account in the balance sheet and the accounts payable liability in the balance sheet. Virtually every business reports accounts payable in its balance sheet, which is a short-term, non-interest-bearing liability arising from buying on credit.

One source of accounts payable is from making inventory purchases on credit. A second source of accounts payable is from expenses that are not paid immediately. Therefore, at this point I divide the total balance of the company's accounts payable liability into two parts, one for each source (refer to Exhibit 6.1 again).

The previous two chapters connect an income statement account with a balance sheet account. In this chapter we look at a connection between two balance sheet accounts. The linkage explained in this chapter is not about how sales revenue or an expense drives an asset, but rather how inventory drives its corresponding liability.

The company in this example is a manufacturer, which means it makes the products it sells. To begin, the company purchases raw materials needed in its production process. These purchases are made on credit; the company doesn't pay for these purchases right away. Also, other production inputs are bought on credit. For example, once a month the public utility sends a bill for the gas and electricity used during the ...