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

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Historically, companies have forecasted their cash position by using an indirect method based on their quarter-end financials. But as the pace, complexity, and globalization of business environments increased, the need for a more immediate and hands-on view of cash led some companies to begin adopting a direct method for cash flow forecasting. When COVID-19 hit, most early adopters of direct cash flow forecasting had an easier time navigating the fast-moving, ever-changing crisis because they had a better handle on their cash position than those who relied solely on their indirect cash flow forecast. Importantly, using the direct method allowed such companies to make empirical strategic decisions based on what was happening around them with their vendors, customers, or other partners. Now, a lot of CFOs and finance teams want to know, what’s the difference between indirect and direct cash flow forecasting?

Indirect Cash Flow Forecasting Shows the Big Picture

When most people talk about cash flow forecasting, they’re referring to the indirect method, which is derived from your three quarter-end financial statements: balance sheet, income statement, and statement of cash flows.According to Dan Fletcher, CFO of MarkLogic, “It’s useful from a very high level to understand the operational, financial, and investing cash flows.” However, the downside of the indirect cash flow forecast is that it’s not very actionable. Although it typically raises the right questions, it doesn’t answer them. To do that, “you need to dig into things like your historical banking data,” Fletcher says. As for Ron Gill, the former CFO of NetSuite, who is a big proponent of direct method forecasting, he sees the indirect cash flow forecast as a purely accounting exercise—a literal 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 Zeroes in on the Ground Game

On the other hand, direct method cash flow forecasting doesn’t wait until the end of the quarter to see how your prediction matched reality. Instead, throughout the quarter, you closely monitor all the information that tells you what cash is coming in and going out, such as:

  • Payroll runs
  • Accounts payable runs
  • Accounts receivable runs
  • Tax obligations
  • Leasing and insurance payments
  • Stock payouts, if you’re a public company

The direct cash flow forecast gives you two invaluable things, according to Gill. The first is greater confidence in the accuracy of your cash forecast. The second is the ability to consider and make more informed strategic decisions even in the very short term—no matter what’s going on, including an unprecedented pandemic.

Real World Meets Real-Time Cash Forecast

There’s still a purpose for the indirect cash flow forecast, but the COVID-19 pandemic underscored the need to be able to see your business’s week-in-week-out or even its day-in-day-out cash position. Tesorio’s automated digital finance tools help bring together the information you need to build a direct method cash flow forecast. Find out how by requesting your demo today.Learn more about direct method cash flow forecasting by listening to Tesorio’s recent webinar, Solving the Cash Flow Disconnect.