Sound Financial Decision Making for Entrepreneurs: Can the GAAP Cash Flow Statement Mislead?

Article excerpt

INTRODUCTION

According to the U.S. Census Bureau, the annual number of start-up firms has been relatively stable for decades, hovering around 600,000 per year. Stangler and Kedrosky (2010) point out that the number remains constant over time despite changes in economic conditions and markets, and longer-cycle changes in population and education. Stable start-up rates require stable financial decision-making to ensure firm survival. Successful entrepreneurs provide change that spurs growth in our markets and economies. Successful entrepreneurs provide valuable products and services to society and create new jobs. Conversely, if entrepreneurs fail, their employees lose their jobs, customers lose access to products and services, and there are fewer changes and innovations to spark economic growth.

A company with solid liquidity is not only able to meet short-term financial obligations, but also has enough cash to take advantage of attractive business offers as they arise. It is important for business owners to understand their financial position in order to maintain adequate financial control of the company and make sound business decisions.

This paper provides an introduction to an alternative method of analyzing the cash flow of a small business. The method we introduce is called the Patton Cash Flow Statement (PCFS). We believe this new method is more appropriate for small business owners to use because it is easier to understand and provides a more realistic view of a company's cash flow and liquidity than does GAAP's indirect method cash flow statement.

LITERATURE REVIEW

Understanding cash flow is commonly viewed as one of the most important skills entrepreneurs can have in order to make sound financial business decisions that ensure firm survival and growth. We see entrepreneurial finance classes being offered in many premier universities such as MIT, Babson, and Harvard. In fact, the first line of Harvard's course description reads, "Entrepreneurial Finance is designed to help managers make better investment and financing decisions in entrepreneurial settings," (Sahlman, Lassiter, and Nanda, 2010).

Beyond entrepreneurship educators, entrepreneurs themselves and their financial advisors also place great emphasis on the importance of understanding and managing cash flow. Anderson, Envick, and Roth (2001) surveyed 103 entrepreneurs and 95 financial advisors to determine what they thought were the most important financial topics for entrepreneurs to understand. Entrepreneurs were surveyed because of their experience in dealing with the financial function of operating a business. The financial advisors were surveyed because of their expertise and also because they provide services to entrepreneurs. Both groups used a seven-point Likert scale to rate the importance of 30 different finance topics for entrepreneurs. The entrepreneurs identified "cash management and projecting cash flows" as their number one ranked topic. It ranked at number two for financial advisors. The financial advisors identified "forecasting and financial statements" as their number one ranked topic and this ranked at number two for entrepreneurs. And both groups ranked "financial ratio analysis" at number three. It is clear from these results that both entrepreneurs and their financial advisors believe that effectively managing cash flow is essential for success, as well as understanding financial statements and ratios.

Generally Accepted Accounting Principles (GAAP) are used by firms to prepare, present, and report financial statements. The three statements used to help entrepreneurs understand their financial position include: 1) the balance sheet, which is a snapshot of a firm's financial resources and obligations at a single point in time; 2) the profit and loss statement, which summarizes a firm's financial transactions over an interval of time; and 3) the cash flow statement, which reflects a firm's liquidity and includes only inflows and outflows of cash and cash equivalents. …