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Cash Flow 101: Direct Vs. Indirect Forecasting

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Identify a forecasting technique that works for you to improve cash flow management.

The way you manage your business’ cash flow has a positive or negative effect on your resources, profitability, and growth potential. If you mismanage your cash flow, your company won’t have enough resources to develop new products or improve customer service, will be unable to leverage opportunities, and limit your chances of attracting talent.  One of the ways to improve cash flow management is through forecasting.

Cash Flow Forecasting Defined

Your company’s cash flow statement provides you with a recap of the amount of cash going in and out of your business. Forecasting projects the cash flow of your business within a certain timeframe. This period can be the following month or several months based on the current financial data you have. Forecasts are not 100% guaranteed but they provide you with insights into how much cash your business may need to remain profitable or overcome challenges it encounters.

What are the different methods of cash flow forecasting?

Many companies that create a cash flow forecast use two methods, which are direct and indirect. Factors that businesses consider when it comes to choosing a method include:

What is direct forecasting?

This forecasting cash flow management approach is a bottom-up accumulation of transactions your business expects to make. Direct forecasting is a possibly tedious method because of the need to gather as much financial data as possible. However, this approach provides you with the best accuracy whenever you make forecasts for short-term cash flow.

These are some of the things to consider whenever you implement direct cash flow forecasting:

Direct forecasting is part of an effective cash flow management strategy. Implement it properly by concentrating on the cash you collect. Don’t rely on accrual accounting because it records expenses and revenue that you earn compared to when you receive a payment. When you make assumptions, you should have a clear understanding of the time it takes customers to fulfill payments. Include the percentage of customers that fail to pay.

What is indirect forecasting?

Companies both big and small use the indirect approach for external and formal forecasting. This process provides an overview of expected cash flow and allows you to formulate a long-term cash flow strategy. This method uses previous financial statements whenever you make a historical statement of cash flows. One of the differences with this approach is it uses forecasted financial statements.

Here are some ways you can use the indirect method when creating a cash flow forecast:

The abovementioned ways allow you to use the indirect cash flow forecast method effectively. This approach allows you to make cash projections. Doing so enables you to implement effective cash flow management strategies. Managing your cash flow opens growth opportunities for your growing business. You’ll have enough resources to take calculated risks such as developing new products or services or investing in a new branch you’d like to open. You will also be able to pay your dues on time and invest in the skills of your employees.

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