The Direct and Indirect Method of Cash Flow Forecasting: Which Should You Use?
What’s the difference between the direct and indirect method of cash flow forecasting? You may already know that your cash flow forecast tells you what your future bank balance will be and helps you to find out if your business will have the right amount of money at the right time. But did you know that there are two ways to calculate a cash flow forecast? And that each could provide you with different figures? These are called the direct and indirect method of cash flow forecasting.
The direct and indirect methods of cash flow forecasting affect the ‘cash from operating activities’ section of cash flows and not ‘cash from investing activities’ or ‘cash from financing activities’ sections.
This blog will help you understand which method of cash flow forecasting to use to ensure you have the right information at the right time.
The Direct Method of Cash Flow Forecasting
This is the preferred method of calculating cash flows for industry bodies such as the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) because it takes all known cash inflows and outflows from operating activities and uses this to build a forecast based on actuals. This means your forecast is highly accurate in the short to medium term but this method requires some guess work to make predictions for the long term.
Despite the direct method being described in a Journal of Accounting and Finance publication as being more desirable and useful to third party users, only 2-3% of firms use this method to calculate cash flows.
This is because the direct method is simpler in theory but becomes difficult if the company has lots of transactions in the operations section of the cash flow statement, as these will all have to be tallied and each transaction will have to be analysed to determine if it actually involved cash. Direct cash flow forecasts from operations include all bills and invoices tied to your company, and can also include tax and interest.
The direct method can be cumbersome as some businesses don’t have the information required at hand. This is especially true if they are using accrual accounting which lumps cash and credit together.
However, if you have all the information at hand and have the ability to collate this, then the direct method becomes extremely powerful for forecasting in the short to medium term.
Best for: Short to medium-term planning
The Indirect Method of Cash Flow Forecasting
The indirect method is the most widely used method of cash flow forecasting as it is simpler to do manually. As a result it is estimated in a ‘Financial Accounting for MBA’s’ report that 98% of businesses use this method.
Forecasts are derived using the P&L and balance sheet, starting with the net income for the period you want to examine then adding and subtracting balance sheet items that either affect profit (not cash flow) or ones that affect cash flow (and not profit). So if you wanted to subtract the cost of depreciation of a new piece of equipment then you wouldn’t also subtract the outright cost to buy the equipment too as you are spreading the cost out over the lifetime of the purchase.
The indirect method is useful for long-term planning as it shows the amount of cash required to fund long-term growth and capital projects. But when it comes to short to medium term planning the indirect method lacks accuracy.
Furthermore, while the direct method is said to be easier for third parties to understand, the indirect method is thought to be easier for users to analyse.
Best for: A long-term view of your cash flow
The direct and indirect method of cash flow forecasting: which is better?
The main take away from this is that there is no one correct way to do cash flow forecasting — both the direct and indirect methods have their uses. In fact the FSAB believes neither method has enough benefit to be used solely over the other and that as neither method can be completely accurate for the short, medium and long term, employing both the direct and indirect methods will result in the most accurate information.
Historically, the direct method of cash flow forecasting has required a lot of effort to produce an accurate forecast but now Float does the heavy lifting for you!