There are two different ways a company can put together their cash flow forecast; the direct method and the indirect method. Whilst the indirect method uses accounting data such as the balance sheet and the profit and loss accounts, the direct method predicts exactly when cash will be coming in and out of the business.
The direct method
Direct cash flow forecasting predicts when cash will be coming in and out of the business at specific points in time. It tries to identify when payments will be made on the exact day or week in a month. For example, when the payment has actually been made rather than when the invoice was sent out. As the forecast is based on predicted actuals, it creates more accuracy especially in the shorter-term.
The direct method includes all types of transactions including credit and cash transactions as well as bills, invoices and tax.
The indirect method
The indirect method of cash flow forecasting is more widely used amongst businesses. It is a simpler process that uses the balance sheet and profit and loss statements in order to predict cash flow.
This process comes in handy when there is a higher volume of transactions. By using data that has already been recorded, you have the information needed to put together your cash flow. The data is converted to the cash flow by adjusting the net income to a cash basis.
Data from the balance sheet is used to determine any cash from operating activities by adding in depreciation and earnings before interest and tax. It also predicts cash flows from investments and potential loans. Taking information from the profit and loss statement and balance sheet can help to predict long-term growth for the business.
Which method is better?
There’s no right and wrong way to put together your cash flow forecast. Each business is different and may prefer a certain way. For example, companies with more transactions will find the direct method time-consuming and may benefit from the simpler indirect method, whereas, a smaller company planning for the short-term may find the direct method better suited for their business.
The pros and cons of the direct method
Direct cash flow forecasting is a more accurate way of predicting when cash will be coming in and out of the business bank account. By basing the forecast on anticipated actuals, you are much more likely to get a more realistic result as there are often delays in payments.
Despite this, the direct method isn’t ideal for longer-term forecasting as accuracy decreases further down the line. In addition to this, companies with a large volume of transactions will find it difficult to record every transaction.
The direct method is more suited for third party use and short-term planning and analaysis. Yet for a long-term overview, the indirect method may be more beneficial.
The benefits of the indirect method
The indirect method is more commonly used because it takes data that is already there, thus being a simpler process for cash flow forecasting. Despite this, it can lack accuracy in the short-term and can be difficult to perform variance analysis.
The indirect method can, however, be really useful for long term growth strategies and capital projects and provide better insight within the company for the future of the business.
The main take away is that there is no correct way to create your cash flow forecast as each method has its benefits and drawbacks. If you are able to, both the indirect and direct cash flow forecast may be more helpful for approaching both short-term and long-term business strategies.