When building a financial model, forecasting cash is often the key topic of discussion. Cash flow forecasting allows you to manage your cash and plan future expenditures, as well as aiding strategic planning.
We often get asked whether a direct cash flow or an indirect cash flow (or both) is best to forecast. The short answer is “it depends” – it depends on the nature of the business as well as the purpose and timeline of the model.
1.Direct cash flow
A direct cash flow presents all cash receipts and payments of a business in a given period. This is especially helpful when planning for the short term. It provides a more accurate set of forecasting on a business’s liquidity so that any shortfalls in the near future can be identified in a timely manner.
A direct cash flow provides information in a significantly different fashion than an indirect cash flow. It is much more granular and therefore typically more complex and technically harder to model. However a direct cash flow will give you the ability to easily assess key cash transactions in a given period i.e. what is truly affecting cash.
2.Indirect cash flow
An indirect cash flow will start with the Profit and Loss and adjust for Balance Sheet movements to derive cash flows, and will therefore show non-cash transactions (e.g. depreciation as a non-cash cost will be added back to profits in deriving the indirect cash flow).
This approach is helpful for highlighting the role of Balance Sheet working capital movements (e.g. movements in debtors and creditors).
An indirect cash flow is in line with most statutory accounts and is what investors are usually used to. This method gives a bigger picture view of the business i.e. the cash conversion from profit to cash, which you wouldn’t be able to do with a direct cash flow.
So which forecasting method is best?
There are pros and cons of both direct and indirect cash flows.
A direct cash flow highlights total expected receipts and payments (e.g. the timing of ‘lumps’ of cash expected to be received from customers or paid to suppliers) and so becomes helpful for decisions around planning and managing cash flows in the short term. This is particularly handy for businesses who are going through a restructuring phase.
The indirect method on the other hand highlights the impact of working capital movements on a business’s cash flow and so becomes beneficial for businesses who want to use their forecast to explore the impact of working capital management e.g. as a business grows and expands.
And of course, sometimes there may be a need to model both a direct and indirect cash flow. The management team may find a direct cash flow more useful, especially if there is a significant disconnect between profit and cash due to big timing differences e.g. billings upfront causing deferred income, which is smoothed evenly in the Profit and Loss. In this case, it may be helpful to have a direct cash flow as it can help to see what is happening transactionally. However, for a deals purpose a business may also require an indirect cash flow for long term planning. In this case, it is key to have a check in the model to ensure the cash balance in both methods match one another.
Either way, as a modelling team, we at Grant Thornton have experience in both cash flow forecasting methods. We take time to understand your business and your requirements to see which method is best in a forecasting financial model for your business. So please get in touch!
