Direct cash flow forecasting relies on the company’s cash collections and disbursements to calculate cash flow. The inputs in direct cash forecasting are upcoming payments and receipts organized into units of time like day, week, or month. These units of time are then combined to the length of time that the forecast is set to cover.
How is it constructed?
By evaluating upcoming receipts from debtors and payments from creditors.
When calculating cash flows from operating activities, companies may choose to employ the indirect method. The indirect method estimates cash flows by identifying non-cash transactions that are included in the net-income calculation and then eliminating them from the computation.
How is it constructed?
Different derivations from the income statement and the balance sheet (adjusted net income, Pro-forma balance sheet, and accrual reversal method) are taken into account.
Adjusted Net Income (ANI): It is derived from operating income, either EBIT or EBITA, changes on the balance sheet are then applied, such as Accounts Payable, Accounts Receivable, and inventories to forecast cash flow.
Pro-forma Balance Sheet (PBS): The PBS method looks at the projected balance sheet cash account at a future point in time.
Accrual Reversal Method (ARM): The ARM is a hybrid of the Adjusted Net Income and direct methods and it uses statistical analysis to reverse large accruals and calculate the cash movements for individual time periods.
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.
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.
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.
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.
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.
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.
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