Why do some business owners forecast cash flow with near-perfect accuracy, while others face constant surprises? The difference often lies in choosing the right cash flow forecasting method—a critical step to ensure financial stability and make informed decisions.
As a CFO and chartered certified accountant with over 20 years of experience—featured in The Independent and partnered with leading software like Agicap—I’ve helped hundreds of businesses select the right cash flow forecasting method to overcome cash flow challenges.
In this guide, you’ll learn:
- Overview of Methods: The two main cash flow forecasting methods—Direct and Indirect—and their pros and cons.
- Deep Dive into the Indirect Method: Understanding its complexities and subtypes.
- Selecting the Best Method: How to choose the right approach to ensure financial stability and make informed decisions based on your industry, business size, and economic conditions.
Having refined these cash flow forecasting methods over two decades, I’m excited to share the framework that has helped countless businesses choose the right method to achieve financial stability and make informed decisions.
3 Key Takeaways
Direct Method: Ideal for businesses needing short-term accuracy and frequent updates. Perfect for small and medium-sized businesses with straightforward cash flows.
Indirect Method: Best for businesses needing long-term strategic planning. Suitable for companies managing multiple revenue streams, capital investments, or those with a complex financial structure.
Combination: Using both methods can offer the best of both worlds—short-term control and long-term visibility—ensuring your business remains financially healthy in both the short and long term, which is a best practice for effective cash flow management.
Which Cash Flow Forecasting Method Suits Your Business?
There are two primary methods of cash flow forecasting:
- Direct Cash Flow Forecasting Method
- Indirect Cash Flow Forecasting Method
Each method serves a different purpose, with the direct method focusing on short-term visibility and the indirect method providing a longer-term, strategic view.
Direct Cash Flow Forecasting Method
The Direct Cash Flow Forecasting Method involves tracking actual cash inflows and outflows over a specific time period (daily, weekly, or monthly). It’s ideal for businesses that need short-term cash flow visibility, allowing owners to react quickly to their cash position and make informed decisions based on their cash flow estimates or budget.
This method works best for:
- Small and medium-sized businesses with predictable cash flows, such as retail shops, service-based businesses, or e-commerce companies.
- Business owners who need real-time insights to ensure liquidity for upcoming obligations like payroll or supplier payments.
By focusing on actual transactions, the direct method gives a real-time snapshot of your business’s cash position, helping you ensure liquidity for operational expenses.
However, while the direct method is excellent for short-term cash flow management, it can be labour-intensive, especially for businesses with high transaction volumes. Additionally, it’s more suited to short-term financial management and doesn’t provide insights into non-cash elements like depreciation or changes in working capital.
Watch a step-by-step video walkthrough of how the direct cash flow forecasting method works and how you can implement it in your business. This video will guide you through setting up a cash flow forecast that tracks inflows and outflows in real-time.
Once you’ve watched the video, you can download my free cash flow forecasting template to get started right away. The template is designed to be simple to use and customizable for your specific business needs.
Indirect Cash Flow Forecasting Method
The Indirect Cash Flow Forecasting Method takes a broader, more strategic approach by starting with net income from your income statement and adjusting for non-cash items like depreciation, as well as changes in working capital. This method is particularly effective for medium to large businesses that need longer-term insights into their financial health.
The indirect method is ideal for businesses looking to:
- Assess cash flow needs for future investments or business growth.
- Manage and Leverage financial instruments , such as loans and capital investments.
Did you know, indirect method can be further categorized into three sub types?
These subtypes are advanced cash flow forecasting methods , which we as finance professionals use for complex cash flow situations. As a business owner, you do not have learn this in details. I am going to cover them in brief in the next section, so that you are aware of the best practices in cash flow management.
Before I do that, let me share with you the flow chart, I have created for you to simplify the process of selecting the right cash flow forecasting method.
Three Types Of Indirect Cash Flow Forecasting Methods
There are three distinct subtypes of indirect cash forecast method you can use, which are ANI, PBS and ARM.
Let me explain.
1. ANI (Adjusted Net Income)
The Adjusted Net Income (ANI) method begins with your company’s operating income, typically EBIT or EBITDA, and adjusts for changes in balance sheet accounts such as receivables, payables, and inventories to provide a more accurate cash flow projection. It’s an effective method for medium-term forecasting (up to 1 year).
For example, one of my clients is a growing retailer selling women clothes based in King cross, London. I implemented ANI to adjust for fluctuations in inventory and accounts receivable. I wanted to ensure a clearer understanding of cash flow over the next year as it expands to a new location in Victoria, London.
2. PBS (Pro-forma Balance Sheet)
The Pro-forma Balance Sheet (PBS) method forecasts the entire balance sheet to project the cash position. If all balance sheet items—such as assets, liabilities, and equity—are accurately forecasted, the projected cash balance will also be accurate.
From my experience working with clients over the years, this is suitable for manufacturing companies planning for major expansion. They can project how withdrawing loan for new equipment affect both their working capital and debt to cash flow ratio. I have also used this method for dental practices as they buy expensive clinical equipment.
3. ARM (Accrual Reversal Method)
The Accrual Reversal Method (ARM) reverses large accruals, such as revenues or expenses that haven’t yet resulted in actual cash flow. ARM can provide weekly or daily forecasts, making it particularly useful for businesses that need to adjust cash flow forecasts frequently.
From my experience ARM is mostly useful for service- based business like creative agencies. They use employees and freelancers to work on projects. Sometimes project tends to straddle more than few months and so the business may not get paid earlier. In this case, business has to accrued for freelancers and payroll costs associated with project cash inflow. I have used this method for creative agencies and has worked well.
What Are The Factors to Consider When Choosing the Best Cash Flow Forecasting Method
You need to consider these factors to choose the best cash flow forecasting method for your specific sector and sitatuion.
1. Define Your Business Objective
Are you looking for short term to ensure you have cash to ensure liquidity and working capital?
Or
Are you looking to make a quantum leap to making long-term strategic business decisions?
2. Consider Business Complexity
How complex is flow of cash in your business?
Does your business make prepayments for the costs and expenses in advance or you receive payments up front from your customers as deposits and then you pay your vendors in few months? In which case, you need accrue for the costs.
3. Evaluate Data Availability
How easily is data available to prepare cash flow forecast?
Does the data need to come from multi- entities, multi- departments and multi- bank accounts, if yes, from my experience indirect method is simpler, faster and easier to execute
4. Match Your Forecasting Needs
You can simply create two versions of the cash flow forecast.
Direct method for short term cash flow visibility needs.
And Indirect method for focusing on longer-term.
5. Assess Capacity and Resources
Do you or your bookkeeper have the capacity and ability to do complex cash flow forecasting? If not you should adopt direct cash forecasting method.
Insight
Direct method is the most preferred method for business owners and entrepreneurs seeking to ensure they have enough cash on hand. I have hardly seen any business owners looking at or preparing cash flow forecasts using an indirect method. This is because a direct cash flow forecast makes it easy for a business owner to understand what's going on.
Case Study: How Choosing the Right Forecasting Method Helped a UK Pre-Owned Handbags Retail Business Improve Cash Flow
My Client Overview
My client is a UK-based retail business selling pre-owned handbags based in Bond Street, London, operating both an online and physical store. I have not taken the name of the business and the owner’s name to protect the identity of my client. They were experiencing frequent cash deficits month to month, which made it extremely difficult to cover month-end payroll on the 30th, regular direct suppliers every two weeks payment run and rent on the 1st of the month.
Their revenue was relatively consistent at average£47,250 per month, but their cash management was very poor. They juggled cash to pay the vendors like an entertainer juggles the balls in a circus.
Challenge:
The business owner was relying on gut instinct instead of an accurate cash flow forecast. When I looked at their cash position in QuickBooks Online accounting software, they had £2,763.27 in the bank account, but rent of £6,000 (£5000 plus VAT) was due next week on May 1st, 2024, and net salaries payment of £9.756.29 was due within the week on May 30th. They needed a cash flow forecasting process that facilitates short-term visibility to avoid these nasty surprises and get a grip on cash flow.
Action Plan
I found out they have not prepared cash flow statements for ages. I used cash flow forecasting software integrated with QuickBooks Online to set up automation for tracking cash inflows and outflows.
I implemented the Direct Cash Flow Forecasting Method based on their sector as retail, size of less than £500k annual revenue and specific situation which is ensuring working capital.
The customized cash flow forecasting spreadsheet download from the software I prepared allowed his bookkeeper to streamline the tracking of cash receipts and payments.
It answered one crucial question lingering in my clients’ mind- when and if I am going to run out of money.
In details, it did the following .
Cash Inflows:
The spreadsheet tracked revenue from in-store and online sales, totaling on average £45,725 for the months June, July and August 2024 .Daily sales varied between £1,4205 and £2,125, with online payments being processed from Barclaycard postal within 3 working days and 7 days from Amex.
Cash Outflows:
They started closely monitored expenses and the timing of outflows too such as rent (£6,000/month) on 1st of the month, inventory restocking (£15,275/month) on 22nd of the month, payroll (£9,800/month) on last working day of the month, and smaller operational expenses (subscriptions, accounting fees, utilities, marketing, etc. totaling £6,725/month). They also accounted for irregular one-off expenses like equipment maintenance.
Having forecasted accurate cash inflow based on previous sales figures covering best months, seasonality, occasions and also outflows based on historical outgoings, accounts payable and planned expenditure, they were able to identify cash flow gap early on.
Result
Within three months June, July and August 2024, the business went from facing severe cash flow blindfolded to having a cash visibility. As a result, I helped them figure out by delaying non-essential inventory purchases by one week on 22nd of the month they could have an additional £15,750 on hand to cover rent and payroll during critical times when business also needs to pay VAT.
They now have a clear plan when to buy new stock without compromising their liquidity. As a consequence, they were able to avoid short term high interest loans
How Is Cash Flow Forecasting Method Different From Cash Flow Forecasting Model?
Cash flow forecasting method and cash flow forecasting model are often confused by business owners and even some novice finance professionals. However, there is a key distinction between the two.
The difference lies in their focus:
A cash flow forecasting method focuses on the technique used to predict future cash flow. It involves the specific approach (such as direct or indirect) used to estimate cash inflows and outflows over a given period.
A cash flow forecasting model is the framework or tool that applies these methods. It typically generates forecasts using formulas, assumptions, and scenarios and allows for the practical implementation of the chosen forecasting method.
One of common questions I get asked by clients is how to choose the right cash flow forecasting model for your business. To help address this, I’ve written a comprehensive guide: Cash Flow Forecasting Models: Which One Is Right For You?
Your next step
By now, you should have a clear understanding of how to choose between these two methods. The key is to align the method to your business sector, size and situation.
You have two options.
Option 1- Master Cash Flow Forecasting
You can obtain comprehensive insights that cover all aspects of cash flow forecasting if this is an area you need to master on. You can check out my guide: Cash Flow Forecasting- The Definitive Guide For Ambitious And Growth-Minded Business Owners.
Option 2- Speed Up Your Customised Cash Flow Forecasting Method
Are you ready to speed up the cash flow forecasting method?
If yes, why don’t you book a call with one of my team?
My team will diagnose the movement of cash in your business, advise on the best method, and provide my proprietary cash flow forecasting step-by-step template.
Here’s the link to book the call.
Look forward to customising your cash flow forecasting method.
