Direct cash flow forecasting vs. indirect cash flow forecasting: What would work for your treasury?

For picking the right fit for your company, you must first assess your company’s size, mission, performance, and budget before deciding on the best cash forecasting method and tools.

Pros and cons of direct cash flow forecasting

Pros:
Direct cash forecasting allows for more detailed analysis and visibility, as well as the prevention of cash shortages during turbulent periods due to the high accuracy achieved for the short term. It helps to work closely with banks to ensure that current balances are accurate and that credit revolvers are used appropriately. Direct or short-term forecasting is better to manage day-to-day funding decisions and investment opportunities.

Cons:
Direct cash flow forecasting isn’t suited for longer-term forecasting as the accuracy decreases and becomes difficult if a company has lots of transactions in the operation and it. It can be challenging as some companies don’t have the information required at hand, especially if they are using accrual accounting.

Pros and cons of indirect cash flow forecasting

Pros:
The indirect method is useful for long-term decision-making as it shows the amount of cash required to fund long-term growth and capital projects such as long-term investments and M&As. Moreover, indirect cash forecasting can be done in a variety of ways such as Adjusted Net Income, Pro Forma Balance Sheet, or the Accrual Reversal Method.

Cons:
It is difficult to perform variance analysis for indirect or long-term forecasting. It isn’t very useful in assisting with operational day-to-day cash management and is limited to the intervals of the financial plan. Moreover, the accuracy is low if multiple factors like seasonality and scenarios are not taken into account.

How direct cash flow forecasting helps treasury

• Analyzes daily cash movements through high granular visibility
• Evaluates consumer payment trends to identify slow-paying customers
• High visibility into cash requirements to manage debts easily
• High short-term accuracy
• Works closely with banks for balance or credit management

How indirect cash flow forecasting helps treasury

• Utilizes information from the income statements and balance sheets
• Decides on currency conversion rates and cash distribution
• Better quantification of profits by reducing borrowing costs
• Supports long-term decisions related to cash deployments and investments

Generally, companies start with direct cash flow forecasting to understand their daily cash movements. This helps them to identify borrowing or investment opportunities. Eventually, they switch to indirect cash flow forecasting as the company expands or plans for acquisitions. Moreover, each business is different and may prefer a certain way. Companies with more transactions usually find the direct method time-consuming and may benefit from the indirect method. However, a smaller company planning for the short-term may find the direct method better suited for their business. In conclusion, both direct and indirect cash flow forecasting is helpful for companies for implementing and improving their short-term and long-term strategies.