Many businesses want to be able to see how much cash they will have in the bank over the coming days, weeks and months. There are two ways to prepare a cash flow forecast: the direct method and the indirect method. The direct method involves looking at all upcoming cash receivables and payables to forecast what and when cash will move in and out of the business.
It can be hard for a business to monitor all their future transactions. But this granularity and accuracy is exactly what a business needs to make confident decisions about investment and drawings.
That’s why many industry standard bodies recommend the direct method of cash flow forecasting. These include the International Accounting Standards Board (the international standard setting body of the IFRS Foundation) and the Financial Accounting Standards Board (FASB).
The indirect method uses accrual accounting data and makes adjustments to create a cash flow forecast. This is complex because you must start by first excluding non cash items such as depreciation and amortisation. Then you have to begin the process of adding in cash items such as tax and interest.
To derive a forecast using the indirect method, one must use accounting data rather than projected cash movements. This means that they often lack detail and are more difficult for many business professionals to understand.
A 2013 survey by the FASB of their membership found that “most preparers and users agree that using the direct method is a more effective way to convey information”.
In a 2009 survey by the Chartered Financial Analysis Institute (CFA), 63% of respondents agreed that the information provided in a direct cash flow statement improves financial forecasts
Furthermore, numerous studies have proven that the direct method is better at predicting future cash flows than the indirect method. For examples, see Krishnan and Largay 2000, Cheng and Hollie 2008 and Orpurt and Zang 2009.
The direct method does have disadvantages. For example, it requires you to have reconciled accounts. In the past the effort required to do this meant it was extremely difficult to use the direct method. These days, however, many accounting systems are in the cloud and connect to bank feeds, making reconciliation much easier.
Also the more transactions a company has, the harder it becomes to use the direct method. Again, though, cloud accounting has streamlined much of the admin required. And we designed Float specifically to make this process much more efficient.
Finally, you really need to have the right data to hand. If you are only doing accrual accounting (which lumps cash and credit together) then you will need to have a separate data set to use the direct method (which can require a bit of extra effort).
At the end of the day, however, if your numbers are up-to-date, the direct method has many benefits:
Both the direct and indirect methods have their uses. In fact the FASB believes neither method has enough benefit to for use solely over the other
The indirect method requires less data input and is most useful for long term planning. This is because it shows the amount of cash required to fund long term growth and capital projects (something the direct method is less good at).
If you want accuracy and detail over the short-to-medium term, then you should use the direct method. It is especially effective for ensuring you are managing your cash effectively. It also helps make sure you have the funds available when you need them. This enables you to invest or withdraw as much cash as possible without jeopardising the business.
You can build a direct forecast using a spreadsheet, which you update each day with actuals. Or you can start a trial of Float today to create a cash flow forecast using the direct method; twice the accuracy in half the time!