You know what cash flow forecasting is and why it’s important. What you may not know is that your company’s cash flow statements can be prepared in one of two ways: direct and indirect.
Why would a business choose one cash forecasting method over another? Let’s compare the two:
What Is Direct Cash Flow Forecasting?
Direct cash flow forecasting tracks cash flow within specific periods, measuring changes in changes in cash payments resulting from your business’ operating activities. Also called short-term forecasting, this cash forecasting model is relatively simple. Just subtract cash payments from cash receipts and you’re done.
Companies tend to use direct cash flow forecasting as a measure of short-term liquidity for specific points of time in the future. However, as a short-term tool, direct cash management estimates aren’t viable for more than a few months. They must be used in conjunction with long-term cash flow forecasting techniques to be a viable financial planning tool (and ideally, would be used in conjunction with automated accounting solutions that aggregate data and run reports.)
Benefits of Direct Cash Forecasting
- High short-term accuracy
- Identifies slow-paying customers
- Manages debt easier with quick cash inflows and outflows information
- Works closely with banks for balance/credit management
What Is Indirect Cash Flow Forecasting?
The indirect cash forecasting model is a little different. Here, you’ll be estimating how depreciation affects your net income as a way of longer-term forecasting.
This calculation involves pulling net income from your balance sheet and adding/subtracting adjustments to other balance sheet items, like assets or liabilities. This will also include changes to your non-operating expenses, such as accounts payable/receivable, inventory, or other accrued expenses.
Benefits of Indirect Cash Flow Forecasting
- Better quantification of profits by reducing borrowing costs
- Provides insight into cash variance over time
- Supports long-range decision-making across cash deployments and investments
What’s the Difference Between Direct and Indirect Cash Flow?
Primarily, direct cash management tools and short-term forecasting are better for helping executives manage day-to-day activities, funding decisions, and investment opportunities. They’re quick-and-dirty measurements run frequently to ensure the ship stays on course, even during times of economic uncertainty. Leverage your accounting software’s tools to run these reports frequently.
As these projections run further out, they become less linked to short-term cash management and more about long-term strategic planning. Indirect cash flow assessments are too far off to be actionable, but they help highlight important issues that can be addressed through other means. It’s not a question of one being better than the other; they both offer part of the picture.
Additionally, while direct cash flow forecasting techniques are relatively simple, indirect cash flow measures can be done in a variety of ways based on Adjusted Net Income, Pro Forma Balance Sheet, or the Accrual Reversal Method.
When Should Each Method Be Used?
As a rule, companies start out with direct cash flow forecasting to get an idea of daily movements. This is an essential part of measuring day-to-day cash flows and knowing whether to buy/borrow investment opportunities. Eventually, you’ll need to switch to indirect cash flow forecasting as your company expands.
An important point in the direct vs. indirect cash flow discussion is the use of accounting software to keep things organized. Quality accounting software solutions let you automate and generate financial reports based on your own company’s needs and frequency. They’re invaluable tools that take the effort out of reporting and decrease the risk of human error throughout your cash flow calculations.
If you’re familiar with cash flow estimates but need help taking your financial planning to the next level, we’d recommend contacting our team at Gaviti. We’ll show you how to implement new solutions that offer accurate, quick, and scalable solutions for your business growth.