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A blog reader (Sam from – well – somewhere) pointed out a critically important new set of accounting principles called SAAP that are a replacement for GAAP and are described on Long or Short Capital.
One of my most popular blog series ever was on Term Sheets. I’ve been pondering another series for a while and a reader inspired me this morning to start one on Financial Statements.
I think your post this morning opened up a subject area you might wish to develop further. Your point was start with the cash flow because of the confusing nature of GAAP. In fact almost all sophisticated readers of financial statements start with the balance sheet or the cash flow and read the P&L last. I think some posts on balance sheet and cash flow analysis techniques or working capital management for a startup would be useful, for the following reasons:
- I suspect most of your readers are probably young, in their first startup and unsophisticated financially
- You and most of the VC blogging community put a lot of emphasis (correctly) on revenue and revenue growth which leads the unsophisticated to focus almost exclusively on the P&L
- While you correctly talk about cash flow with some frequency the unsophisticated do not understand well the relationship between the cash flow and the balance sheet.
Having taught these subjects for several years and been involved in several workouts/turnarounds, I am confident that balance sheet/ cash flow analysis is not either obvious or well understood (even after an MBA). Good working capital and balance sheet management leads to capital efficiency, a theme I know is dear to your heart.
At the risk of being tedious, boring, ponderous, dull, and monotonous I’m going to take on Financial Statements over the next few months. I hope you eventually find them as stimulating as I do.
Bill Burnham has an excellent rant up on GAAP accounting titled Is It Just Me or is GAAP Completely Broken? In case you don’t know, GAAP stands for “Generally Accepted Accounting Principles” and is a term regularly thrown around when staring at an income statement, balance sheet, statement of cash flows, or any other “supplemental information.”
I’m not a public market investor so I don’t have the twisted experience that anyone that deals with a public company has with GAAP since I don’t really care about understanding the financial statements of public companies (in any great depth.) Bill is – and he does a nice job of covering why GAAP has become such a mess in the public arena.
GAAP is also a mess in the private company arena. I get monthly financial statements for all the companies I’m on the board of (and quarterly for all the companies I’m an investor in.) The presentation varies, but it always includes a balance sheet, income statement, and statement of cash flows. I learned the value of understanding the financial statements early in my life – we were obsessed with them in Feld Technologies (my first company) and I was particularly fascinated with them when I started seeing them from other companies. Numbers stick in my brain and I can do straightforward math on the fly, so it’s easy for me to look at a set of financial statements and figure out what is going on pretty quickly.
Except for when the accountants get in the way. SaaS business models, revenue recognition, FAS xyz rules, tax vs. book, and option value / accounting creates a mess in private companies. All of a sudden I’m starting with the cash flow statement and working backward to actually understand what is really going on.
The irony of all of this is that most young private companies struggle to conform to GAAP, yet present their financials in a way that is clear and helpful – until they start trying to conform to GAAP. Of course, we have the accountants do an audit each year, at which point they ultimately restate things (sometimes minor, sometimes major) – almost always impacting the balance sheet and income statement, but rarely impacting the cash flow statement.
The arcania involved has radically increased in the past few years. I’m finding auditors reversing themselves within one year cycles – at one point they say “do things this way” and then nine months later they say “do things a different way.” It’s especially entertaining when you remind them of their previous approach, they say “we never said that”, and then you present them with the email they originally sent. Any accountant worth his paycheck knows how to say “yes, but it’s different now.”
It’s remarkable what a total waste of time and energy this is, especially when you get into the second order effect of actually trying to figure out what is really going on.
My advice to all entrepreneurs (and investors) is make sure you can read a statement of cash flows. Start there – not with the income statement. Once you understand the actual cash flows for a period, the chances of you catching the GAAP nuances of the income statement and balance sheet are much greater.