This paper investigates the cross-sectional and time-series implications of capital imperfections for inventory investment in retail trade. In particular, it focuses on the relevance of firms’ balance sheet positions in obtaining access to external sources of finance. The paper utilizes an entirely new source of firm-level data at a quarterly frequency; the micro data underlying the published Quarterly Financial Reports (QFR). Under the maintained hypothesis, firms with “weak’ balance sheet positions face a higher-and quite possibly prohibitive-premium on external finance than do firms with “strong” balance sheet positions. Consequently, inventory investment decisions of firms with “weak” balance sheet positions are in large part determined by the availability of internally generated funds-that is, profits or cash flow. A panel data modification of an error-correction model that incorporates internal finance variables and forward-looking expectations of the stochastic process of sales is not rejected by the data. Both the cross-sectional and time-series results are consistent with the existence of capital market imperfections; namely, (1) internal finance is a highly significant-statistically and economically-predictor of inventory investment of firms with “weak” balance sheet positions; and (2) the predictive power of internal finance for inventory investment of firms with “weak” balance sheet positions is highly asymmetric over the course of a business cycle, increasing considerably in recession relative to expansionary times. The quantitative significance of financial factors suggest that a large portion of the observed volatility aggregate retail inventory investment over a business cycle is potentially due to fluctuations in internal finance.