Sound Financial Decision Making for Entrepreneurs: Can the Gaap Cash Flow Statement Mislead?
Cory, Suzanne N., Envick, Brooke R., Patton, Edward B., Entrepreneurial Executive
A person who is "entrepreneurial" constantly seeks different and better products, services and processes. A process is how something is done and entrepreneurial thinkers search for better ways of doing things, instead of blindly accepting what is considered standard or required by others. For example Generally Accepted Accounting Principles (GAAP) are the standard guidelines and rules used to prepare, present, and report financial statements for a wide variety of entities, including small businesses. Even though GAAP provide the standard rules for reporting, are the methods really the best tools for small business owners to use when making business decisions? This paper provides an alternative approach to the indirect cash flow statement, called the Patton Cash Flow Statement (PCFS). After utilizing it with several business clients and then validating it in a controlled classroom environment, we contend that the PCFS is a better tool for small business owners to use when making financial decisions than what is currently required by GAAP.
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.
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 sevenpoint 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. …