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.