What’s the Difference Between Indirect and Direct Cash Flow Forecasting?

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In today's rapidly changing business environment, companies have recognized the limitations of using an indirect method based on quarter-end financials to forecast their cash position. The increasing pace, complexity, and globalization of the macroenvironment have necessitated a more immediate and hands-on approach to cash flow forecasting. While the COVID-19 pandemic served as a catalyst for adopting direct cash flow forecasting, it is important to understand its relevance beyond that specific event. CFOs and finance teams are seeking to further understand: what’s the difference between indirect and direct cash flow forecasting?

Indirect Cash Flow Forecasting Reveals the Big Picture

When discussing cash flow forecasting, the indirect method is often the primary focus. This method relies on analyzing three quarter-end financial statements: the balance sheet, income statement, and statement of cash flows. According to Dan Fletcher, CFO of Planful, the indirect method provides a useful high-level understanding of operational, financial, and investing cash flows. However, its drawback lies in its lack of actionability. While it raises pertinent questions, it does not provide answers. To do that, “you need to dig into things like your historical banking data,” Fletcher says.

Ron Gill, the former CFO of NetSuite and a proponent of direct method forecasting, views the indirect cash flow forecast as a mere accounting exercise—a reconciliation between net income and cash. “The indirect method cash flow statement is useless as a business tool, which is why most businesses just consume the burn, i.e., the number at the end,” Gill says.

Direct Cash Flow Forecasting Focuses on Real-Time Insights

In contrast, direct method cash flow forecasting does not wait until the end of the quarter to assess the accuracy of predictions. Instead, it involves continuously monitoring all relevant information that sheds light on cash inflows and outflows, including:

  • Payroll runs

  • Accounts payable runs

  • Accounts receivable runs

  • Tax obligations

  • Leasing and insurance payments

  • Stock payouts (for public companies)

According to Gill, direct cash flow forecasting offers two invaluable advantages. First, it instills greater confidence in the accuracy of cash forecasts. Second, it enables more informed strategic decision-making, even in the short term, regardless of the prevailing circumstances.

Indirect vs. Direct Cash Flow Forecasting: A Comparison

To provide a clearer understanding of the differences between indirect and direct cash flow forecasting methods, consider the following comparison:

Indirect Cash Flow ForecastingDirect Cash Flow Forecasting
BasisQuarter-end financial statements (balance sheet, income statement, and statement of cash flows)Real-time monitoring of cash inflows and outflows
ActionabilityProvides a high-level understanding of operational, financial, and investing cash flows but lacks actionable insightsOffers actionable insights by closely examining historical banking data
Decision-makingRaises relevant questions but doesn't provide answersFacilitates informed strategic decision-making in the short term
AccuracyRelies on reconciling net income and cash but may not capture real-time changesProvides greater confidence in the accuracy of cash forecasts
Key ConsiderationsHistorical financial data and overall financial healthPayroll runs, accounts payable/receivable, tax obligations, leasing/insurance payments, stock payouts (for public companies)
Business ToolPrimarily an accounting exerciseEnables real-time visibility into cash position for effective business management
ImportanceStill serves a purpose, but may not meet the needs of fast-paced and dynamic business environmentsCrucial for businesses operating in rapidly changing

Real-Time Cash Forecasting in the Dynamic Macroenvironment

While the indirect cash flow forecast still serves a purpose, the COVID-19 pandemic emphasized the importance of having a real-time understanding of a business's cash position on a weekly, daily, or even intra-day basis. To achieve this, companies can leverage automated digital finance tools, such as those offered by Tesorio, which consolidate the necessary information to build a real-time cash flow forecast.

These tools empower businesses to make timely and informed decisions, adapt rapidly to changing conditions, and stay ahead in the dynamic macroenvironment. To explore the benefits of real-time visibility and cash flow forecasting, speak to a finance expert today.

Additionally, you can gain further insights into this topic by listening to Tesorio's past webinar, Solving the Cash Flow Disconnect.