Sound financial decision making for entrepreneurs: can the GAAP cash flow statement mislead?
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 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. The indirect method of the cash flow statement is almost universally used because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method. The indirect method uses net-income as a starting point, makes adjustments for all transactions that involve non-cash operating activities, then adjusts for all cash-based operating transactions. In general, an increase in a current asset account is subtracted from net income, and an increase in a current liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.
One of the authors of this paper is a financial advisor to small business owners, who found that GAAP's indirect method cash flow statement may be misleading for small business owners when making important financial decisions. As a result, a new cash flow statement method was developed and used for multiple clients with remarkable success. This new method is called the Patton Cash Flow Statement.
THE PATTON CASH FLOW STATEMENT
Due to the proprietary features of the Patton Cash Flow Statement (PCFS), only a limited amount of information is provided in this paper. The overall concept is disclosed without a full explanation of how it is generated. In summary, the PCFS was developed by, and has been used extensively by one of the co-authors of this paper to show changes in cash in a more comprehensible, readable and common sense format. It is designed to use common business line items with descriptive subtotals that are intended to be easily understood by financial and non-financial readers of the PCFS.
Some differentiations of the PCFS versus the GAAP cash flow statement include the PCFS' segregation and highlight of amounts that drive several important business factors, such as: (1) shareholder value; (2) liquidity (or balance sheet strength); and (3) loan amounts supported by cash flow. These amounts are shown using common sense, every day business financial components.
Separating the creation or consumption of working capital and the changes in working capital components is an important part of the effectiveness of the PCFS. Increases and decreases in working capital items are a function of two factors; (1) volume, and (2) management. Volume is evident by trends reflected in standard income statements. Management of working capital items is reflected in turns/number of days. The PCFS shows the company's ability to manage working capital items.
In addition to management of working capital components, the primary drivers of liquidity and shareholder values are also shown by the PCFS. We believe the PCFS provides key financial information that is not available elsewhere in businesses financial reports. This key data is provided in a straightforward, common sense format.
The PCFS has been used by multiple companies in a wide range of industries. It is believed to be effective for businesses of any size. However, to date, the PCFS has been applied to entities that range from early stage to about $60 million in sales.
Our study includes a two-phase methodology to test the PCFS: (1) real world application of the PCFS used by businesses to better understand and make decisions for their futures; and (2) a validation of the PCFS in a controlled classroom setting.
PHASE I: REAL WORLD APPLICATION OF THE PCFS
As discussed, the PCFS method has been utilized by one of the authors to assist multiple companies make important financial and business decisions. Three examples are provided below to illustrate the effectiveness of the PCFS.
Company A : In this example, proceeds from real estate sales mask problems of operating losses.
Company A had experienced years of business losses. However, the company's liquidity remained strong throughout this period and the strong balance sheet provided management with a false sense of security. Incorporating the PCFS allowed identification of the source of liquidity, which was the sale of non-operational real estate accumulated by the business over several decades. Using traditional cash flow statements prevented management from being aware of the major liquidity impact of this non-operational cash source. With the PCFS, management clearly saw the disparity between operating business results and the strength of their balance sheet. This essential information provided clarity and reality to the business's cash flow.
Company B: In this example, inventory buildup significantly drains liquidity.
Company B had a strong, liquid balance sheet and was generating working capital on a regular basis. However, liquidity began to decline substantially. The PCFS showed that sales and operating earnings continued to be strong during the period of decreasing liquidity and that the cause of this decline was a large buildup of inventories. By using the PCFS (along with the Mr. Patton's Common Sense Financial Method or CSFM), it was easy to determine that the business continued to perform well, but inventory buildup was depleting liquidity alarmingly. Management's understanding of this led to a decision to hire a full-time manager who was in charge of all inventory purchases and coordination with vendors. This new focus resulted in the necessary decrease in inventories and restoration of liquidity to its prior strong levels.
Company C: In this example, plant expansion that was not funded with long-term capital requires alternative financing.
Company C started a plant expansion without having secured long-term financing to pay for the new building and equipment. There was plenty of cash flow to support a loan on the property. However, a down-turn in the economy, the special-use purpose of the facility and a lack of comparable buildings combined to result in a low appraisal and consequently lenders' reduced loan capacity. The unique information provided by the PCFS (and related CSFM liquidity calculation) resulted in structuring a loan that was a combination of a temporary term loan and use of a portion of the Company's line of credit. An abundance of unfunded amounts on the Company's line of credit made tapping this source of liquidity prudent without concerns about jeopardizing the viability of the business. As payments reduced the temporary term loan balance, the real estate market improved, and the geographic area used by the real estate appraisers was expanded, the Company was able to subsequently procure a long-term loan that funded the majority of the costs of the new facility.
General Observations: from working with numerous other companies.
In today's environment, lenders are constrained by regulators that are inhibiting their ability to loan funds to businesses even though the enterprises have adequate cash flow and/or are well capitalized. The PCFS clearly indicates the amount of cash that operations are generating and retaining. This is accomplished via the segregation of the creation/consumption of working capital and the changes and management of working capital components as discussed above. Also, liquidity as determined by the CSFM (of which the PCFS is a key component) objectively and succinctly calculates the organization's financial strength and identifies the drivers of change in this critical measurement. When lenders do not fully understand, and management cannot succinctly articulate a business' cash flow or liquidity, they will understandably err on the side of conservatism when deciding how much to loan to a company. With the information provided by the PCFS (and liquidity in the CSFM), lenders and borrowers can better structure funding that maximizes the needs of both parties.
PHASE II: VALIDATION OF THE PCFS
In the interest of looking more closely at the possibility that GAAP's indirect method may be misleading, and to further investigate the utility and validity of the PCFS, we embarked on an exploratory case study with graduate students at our university. The course used for this study was a graduate course in financial accounting research and communication. An intermediate accounting textbook was used. One of the topics covered was the cash flow statement with a significant amount of class time devoted to illustration, discussion and preparation of the GAAP statement. Students prepared several cash flow statements and demonstrated their understanding of related complex issues and calculations. All seven students had earned an undergraduate degree in accounting. Four of the seven were currently employed in public accounting and one had completed an accounting internship in public accounting and one in industry but was currently a full-time student. Another student was in the joint JD/MBA program and consequently a full-time student. The seventh student had recently retired from the military and had not yet begun his accounting career.
Two cases were handed out after an in-class demonstration illustrating the preparation of the PCFS. Both cases contained the same financial information: (1) a two-year comparative balance sheet, (2) an income statement for the year and (3) additional details of transactions and events that occurred during the year. Both cases also provided information about the small corporation that was the subject of the case. The company had originated as a sole proprietorship by Thomas, an individual with absolutely no accounting knowledge and a total lack of understanding about the cash flow statement. Consequently, he relied completely on his controller, who was currently unavailable and unreachable, when making financial decisions.
At this point in the case, each group was given a different decision that Thomas had to make very quickly. Group #1's problem dealt with an opportunity to buy merchandise inventory at a substantial discount and Group #2's problem dealt with an opportunity to purchase fixed assets for expansion purposes. In both cases, the situation was described as a "golden opportunity" and decision-making time allowed was only three days. Students were required to prepare both a GAAP cash flow statement and a PCFS. They were told to make a recommendation to Thomas, and to be sure to support their recommendation based on all four financial statements. Further, they were instructed to clearly state the information on the two statements that they had prepared (GAAP cash flow and PCFS) that led to their decision.
Both groups of students recommended using the Patton's Cash Flow Statement for making their respective decision. Members of Group #1 strongly felt that the GAAP statement was "misleading." They indicated that the Patton statement was more informative and more closely related to free cash flow. Members of Group #2 indicated that they began their discussion by relying on and referring to the GAAP statement, but decided that the information presented therein was "not representative of how the company is doing." They were concerned about getting reliable information about the overall financial picture of the company and the results of operations, and they felt the core cash flow, which is part of the Patton approach, was more indicative of true cash flow and preferred it over the cash flow from operations presented in the GAAP statement. Further, they found that the analysis of changes in working capital, which is also part of the PCFS, was also beneficial. It allowed them to focus on operating liquidity. When queried, members of both groups felt that preparation of the PCFS on a monthly or quarterly basis would be beneficial, especially for small business.
Through this two-phase exploratory study, we have reason to believe that the GAAP indirect method cash flow statement can be misleading to entrepreneurs and small business owners. Further, our results indicate that the Patton Cash Flow Statement may provide more information, more clarity of sources and uses of cash, and be easier to understand for entrepreneurs and small business owners who are making important business decisions.
We contend that the PCFS is a better tool than GAAP's indirect cash flow statement for making business decisions. While we understand that GAAP methods are required for reporting purposes, and understand that the traditional financial statements must be taught and understood by business owners, it is essential to provide them with alternative tools that might be better for decision-making purposes that could be the difference between success and business failure. For more information about the PCFS, interested readers should contact one of the authors of this paper.
Anderson, R., Envick, B., & Roth, G. (2001). Understanding the financial educational needs of entrepreneurs: A survey of entrepreneurs and financial advisors. Academy of Entrepreneurship Journal, Vol. 7(2), 111-118.
Kuratko, D. (2005). The emergence of entrepreneurship education: Development, trends, and challenges. Entrepreneurship Theory & Practice, Sept., 577-597.
Sahlman, W., Lassiter, J., and Nanda, R. ( 2010). Entrepreneurial finance. Elective Course Descriptions, Harvard Business School MBA Program. Retrieved June 10, 2010, http://www.hbs.edu/mba/academics/coursecatalog/
Stangler, D.& Kedrodsky, P. (2010). Exploring firm formation. Why is the number of new firms constant? Kauffman Foundation Research Series: Firm Formation and Economic Growth. Ewing Marion Kauffman Foundation.
Suzanne N. Cory, St. Mary's University
Brooke R. Envick, St. Mary's University
Edward B. Patton, Patton Associates