Every founder knows that money makes the world go around. But only some realize just how crucial it is to maintain a healthy budget, especially if you're in charge of a startup. You're facing a unique set of financial challenges and don't have the luxury to monitor every penny that comes in and out.
That's why cash flow forecasting is so important. It allows you to plan, can help you manage your money, identify growth opportunities, and make more informed spending decisions.
But there is more than one forecasting method out there!
As a savvy startup owner, learning how to correctly forecast cash flow and pick the best forecasting method for your unique needs is essential. This article will examine each cash flow forecasting method's differences, advantages, and limitations and how to select the proper method for your business.
Direct Cash Flow Forecasting
Direct cash flow forecasting, or the “receipts and disbursement method,” predicts flows and balances used for the short term, aiming to show cash movements and positions at specific future points.
This straightforward forecasting model helps identify cash inflows, such as sales or investments, and outflows, like expenses or debts.
Direct cash management estimates provide reliable insight into the liquidity of your business for a certain period. However, pairing them with long-term forecasting techniques is important to give you the full picture of your business's performance.
How It's Prepared
Direct cash flow forecasting looks at all tangible transactions occurring in a certain period. This includes actual sales and purchases and any other payment or cash receipt. It also considers payments to vendors and employees, taxes, loans, and other financial obligations.
The process for preparing direct cash flow forecasts is relatively simple. You can use a spreadsheet or accounting software to help you record your transactions and the due dates. Then, you add all the inflows and outflows to get your total cash balance for that period.
Advantages Of Direct Cash Flow Forecasting
Our favorite thing about the direct method is that it’s simple and easy to use daily, so you can quickly identify and address any cash flow gaps before they become a problem.
Some additional advantages:
- A clear picture of cash flow – Gives you a comprehensive and accurate picture of the most critical cash transactions in a given period. Actual cash transactions are more reliable than estimated numbers, and better indicate your inflows and outflows.
- Best for early-stage startups – Perfect if you’re just starting out and have a limited number of transactions and simple revenue structures.
- Easy to update – It’s also quick to update, making it an ideal choice if you have to manage you cash flows daily.
- Enhance business decision-making – Gives you a better understanding of your financial status, which can help inform business decisions and create a stronger foundation for growth.
Limitations Of Direct Cash Flow Forecasting
Despite its advantages, direct cash flow forecasting has some drawbacks that may hinder your view of a complete picture of your long-term financial health. Some additional limitations include the following:
- Limited long-term accuracy – Direct cash flow forecasting only looks at short-term transactions, resulting in inaccuracies when looking at your long-term prospects.
- Non-cash transactions are not considered – You can’t consider transactions such as depreciation or amortization, making it less accurate for businesses with complex accounting needs.
- Not ideal for startups with complex revenue streams – For example, if you have multiple revenue sources or a high level of uncertainty, you may have difficulty using this method to forecast cash flow.
- Reliance on past data – Using old data may not be as effective if your startup is growing rapidly or making changes to its operations.
- Ignores inflation and interest rates – Looking at inflation or interest rates supports long-term planning, which you won’t account for here.
Indirect Cash Flow Forecasting
With indirect forecasting, you get an overview of cash inflows and outflows over a period without focusing entirely on actual transactions. Indirect forecasting is ideal for startups requiring more long-term guidance for expansion or projects.
Definition Of Indirect Cash Flow Forecasting And How It's Prepared
Indirect cash flow forecasting is a method of estimating future cash flows based on an analysis of past financial results. This forecasting type looks at income and balance sheet items such as sales, expenses, assets, liabilities, and equity. It also includes non-cash transactions such as depreciation and inventory.
Preparing an indirect forecast is more complex than direct forecasting. You will need to analyze your financial statements, make assumptions about future performance, and use a pro forma balance sheet to identify the activity that will affect your cash in the future.
Methods Of Indirect Forecasting
You can use several methods of indirect forecasting. These include the Adjusted Net Income (ANI) method, the Pro Forma Balance Sheet (PBS) method, and Accrual Reversal Method (ARM). Each method has advantages and disadvantages, so you must choose the most suitable option for your business.
- Adjusted Net Income Method – This method uses your net income from the past and adjusts it for non-cash transactions.
- Pro Forma Balance Sheet Method – Using a balance sheet that incorporates both historical and anticipated future information. You can do this manually or with accounting software.
- Accrual Reversal Method – To estimate future cash flow activity, this method looks at the difference between your current assets and liabilities.
Advantages Of Indirect Cash Flow Forecasting
Indirect cash flow forecasting has several advantages, making it an attractive option for businesses. If your startup has a complex revenue structure or many transactions, it can be a great way to get an accurate picture of your cash flow over time.
Among the additional benefits are the following:
- Gives a long-term view of business cash flow – Gives you a more accurate picture of your long-term cash flow, which is useful for planning and forecasting future needs and trends.
- Includes non-cash transactions – Unlike direct forecasting, indirect forecasting considers non-cash transactions for a more comprehensive view of your cash flow statement.
- Better suited for businesses with a lot of transactions – Or those with complex revenue structures. Due to the detailed analysis, this method provides a clearer picture of your future cash flow.
- Accounts for future transactions – Allows you to account for future transactions and assumptions to predict various scenarios and plan for contingencies.
- Facilitates better budgeting and planning – You can create budgeting and planning tools that account for external factors such as inflation or interest rates. This can help you make more informed decisions about your business.
Limitations Of Indirect Forecasting
While the indirect method has several advantages, it also has some limitations. Depending on the complexity of your business, direct forecasting may represent the best option. Some restrictions to keep in mind include the following:
- Time-consuming – Preparing an indirect cash flow forecast is more time-consuming than direct forecasting. You must analyze your financial statements and make assumptions about future performance based on the data.
- Difficult for startups – While it can be helpful for established businesses, indirect forecasting may not suit startups lacking historical financial data.
- Based on estimates and assumptions – May rely on estimates and assumptions rather than actual data, leading to inaccuracies in forecasting.
- Not as helpful for short-term cash flow gaps or surpluses – Provides an overall look at your long-term cash flow. It may not help address short-term cash flow gaps or surpluses because of the time it takes to prepare the forecast.
- May require specialized skills or software – Require specialized skills or software to accurately analyze your financial statements and make projections.
- Less precision and accuracy – Unlike direct forecasting, indirect forecasting does not provide the same precision and accuracy in estimating cash flow. However, it is still a valuable tool for businesses looking at the bigger picture.
Comparison of Direct and Indirect Cash Flow Forecasting
Direct and indirect cash flow forecasting have similarities and differences. Depending on your needs and resources, one may provide a better fit to manage cash flow than the other.
Both methods help plan your future needs and make financial projections about how much money is needed to meet those needs. They are also both based on data from past financial statements or transactions.
Research reveals that if a startup had positive financial forecasts made in the past, they would carry that bias with them into current forecasts. This does add a slight risk of overly optimistic forecasts if you don't have access to real-time financial data to keep you accurate.
The following table illustrates the similarities and differences between direct and indirect forecasting:
Choosing The Best Cash Flow Forecasting Method
Before selecting a forecasting method, consider the size and complexity of your business. Direct forecasting may be the best option if you have a small business with limited cash flow history. However, indirect forecasting can provide a more comprehensive view of your future cash flow needs if you have complex revenue structures or many transactions.
Review your business needs and data availability. For example, direct forecasting may be more suitable if you need short-term forecasting or don't have access to past financial statements. On the other hand, if you need long-term forecasting based on detailed data, then indirect forecasting offers the better choice.
If you need help deciding which method to use, seek professional help. An experienced CFO or CPA will help you analyze your business needs and provide advice on the best forecasting method for your organization.
How Do I Use These Cash Flow Forecasting Methods To Make Smart Business Decisions?
You should always keep cash flow forecasting in mind when making decisions as a startup. Cash is a critical asset of any business, and you must plan to make it available when needed.
Do this by combining direct and indirect cash flow forecasting methods and regularly reviewing and updating your forecasts as new data becomes available. You can also use technology to automate forecasting, saving time and getting more accurate results.
Always involve your investors and board members in the forecasting process. By having everyone on the same page, you can make informed decisions about how to allocate resources and capital. This step will ensure your business has enough cash flow to cover operating expenses and invest in new projects or initiatives.
Moving Forward With Cash Flow Management
As a startup founder, you need to understand the differences between direct and indirect cash flow forecasting and the best method for your business.
Direct cash flow forecasting provides a clear picture of the most critical cash transactions that will occur in a certain period, allowing you to identify any potential cash flow gaps and pivot accordingly.
Indirect cash flow forecasting allows for a more comprehensive view of your business's future cash flow needs based on detailed data.
Companies with complex revenue structures requiring long-term forecasting will find this feature invaluable. By combining direct and indirect cash flow forecasting, your business can make smarter resource allocation and capital investment decisions.
If you’re still feeling in the dark, you can find more resources here.
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