Budgeting

Definition: Establishing a planned level of expenditures, usually at a fairly detailed level. A company may plan and maintain a budget on either an accrual or a cash basis.

Business budgeting is one of the most powerful financial tools available to any small-business owner. Put simply, maintaining a good short- and long-range financial plan enables you to control your cash flow instead of having it control you.

The most effective financial budget includes both a short-range, month-to-month plan for at least one calendar year and a long-range, quarter-to-quarter plan you use for financial statement reporting. It should be prepared during the two months preceding the fiscal year-end to allow ample time for sufficient information-gathering.

The long-range plan should cover a period of at least three years (some go up to five years) on a quarterly basis, or even an annual basis. The long-term budget should be updated when the short-range plan is prepared.

While some owners prefer to leave the one-year budget unchanged for the year for which it provides projections, others adjust the budget during the year based on certain financial occurrences, such as an unplanned equipment purchase or a larger-than-expected upward sales trend. Using the budget as an ongoing planning tool during a given year certainly is recommended. However, here is a word to the wise: Financial budgeting is vital, but it's important to avoid getting so caught up in the budget process that you forget to keep doing business.

Many financial budgets provide a plan only for the income statement; however, it's important to budget both the income statement and balance sheet. This enables you to consider potential cash-flow needs for your entire operation, not just as they pertain to income and expenses. For instance, if you'd already been in business for a few years and were adding a new product line, you'd need to consider the impact of inventory purchases on cash flow.

Budgeting only the income statement also doesn't allow a full analysis of the effect of potential capital expenditures on your financial picture. For instance, if you're planning to purchase real estate for your operation, you need to budget the effect the debt service will have on cash flow.

In the startup phase, you'll have to make reasonable assumptions about your business in establishing your budget. You will need to ask questions such as:

  • How much can be sold in year one?
  • How much will sales grow in the following years?
  • How will the products and/or services you're selling be priced?
  • How much will it cost to produce your product? How much inventory will you need?
  • What will your operating expenses be?
  • How many employees will you need? How much will you pay them? How much will you pay yourself? What benefits will you offer? What will your payroll and unemployment taxes be?
  • What will the income tax rate be? Will your business be an S corporation or a C corporation?
  • What will your facilities needs be? How much will it cost you in rent or debt service for these facilities?
  • What equipment will be needed to start the business? How much will it cost? Will there be additional equipment needs in subsequent years?
  • What payment terms will you offer customers if you sell on credit? What payment terms will your suppliers give you?
  • How much will you need to borrow?
  • What will the collateral be? What will the interest rate be?

As for the actual preparation of the budget, you can create it manually or with the budgeting function that comes with most bookkeeping software packages. You can also purchase separate budgeting software such as Quicken or Microsoft Money.

The first step is to set up a plan for the following year on a month-to-month basis. Starting with the first month, establish specific budgeted dollar levels for each category of the budget. The sales numbers will be critical since they'll be used to compute gross profit margin and will help determine operating expenses, as well as the accounts receivable and inventory levels necessary to support the business. In determining how much of your product or service you can sell, study the market in which you operate, your competition, potential demand that you might already have seen and economic conditions. For cost of goods sold, you'll need to calculate the actual costs associated with producing each item on a percentage basis.

For your operating expenses, consider items such as advertising, auto, depreciation, insurance and so on. Then factor in a tax rate based on actual business tax rates that you can obtain from your accountant.

On the balance sheet, break down inventory by category. For instance, a clothing manufacturer has raw materials, work-in-progress and finished goods. For inventory, accounts receivable and accounts payable, you'll figure the total amounts based on a projected number of days on hand.

Consider each specific item in fixed assets broken out for real estate, equipment, investments and so on. If your new business requires a franchise fee or copyrights or patents, this will be reflected as an intangible asset.

On the liability side, break down each bank loan separately. Do the same for the stockholders' equity--common stock, preferred stock, paid-in-capital, treasury stock and retained earnings.

Do this for each month for the first 12 months. Then prepare the quarter-to-quarter budgets for years two and three. For the first year's budget, you'll want to consider seasonality factors. For example, most retailers experience heavy sales from October to December. If your business will be highly seasonal, you'll have wide-ranging changes in cash-flow needs. For this reason, you'll want to consider seasonality in the budget rather than take your annual projected year-one sales level and divide by 12.

As for the process, you need to prepare the income statement budgets first, then balance sheet, then cash flow. You'll need to know the net income figure before you can prepare a pro forma balance sheet because the profit number must be plugged into retained earnings. And for the cash-flow projection, you'll need both income statement and balance sheet numbers.

Whether you budget manually or use software, it's advisable to seek input from your CPA in preparing your initial budget. Your CPA's role will depend on the internal resources available to you and your background in finance: You may want to hire a CPA to prepare the financial plan for you, or you may simply involve them in an advisory role. Regardless of the level of involvement, your CPA's input will prove invaluable in providing an independent review of your short- and long-term financial plan.

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