Fundamental Business Model
In order to understand how accounting works, we need to have a background in the fundamental business model.
A business model is a framework for how a business creates value and for a business to be successful, it needs to develop a product or service that customers will pay for and thus will create a revenue source. A business model is essential to understanding the problem to be solved, how the business will solve it, and the growth opportunity within a given market.
The image below illustrates the business model, i.e. how it is structured to provide a customer proposition.
This business model is built on the five fundamental activities or process flow as outlined below:
- First, the owners or the investors provide the required capital to the business, generally in cash.
- Next, the cash will be converted to another asset that is needed in operations. This may include paying salaries, utilities, purchasing fixed assets, manufacturing inventories, and so on.
- Then, the products or services will be produced.
- The products and services will now be sold to customers/clients and be converted to receivables or may be direct to cash.
- A return will be provided to banks and owners in the form of interest or dividends. Other available cash will be reinvested in the operations.
As you can see here, the business model is essential to illustrate how the money flows in the business which serves as a basis of accounting. Each financial transaction that will occur at any stage will have a corresponding accounting event and shall be recorded in the books.