For many small-business owners, the process of budgeting is
limited to figuring out where to get the cash to meet next
week's payroll. There are so many financial fires to put out in
a given week that it's hard to find the time to do any short-
or long-range financial planning. But failing to plan financially
might mean that you are unknowingly planning to fail.
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 a calendar year and a
quarter-to-quarter long-range 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.
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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 is important to avoid
getting so caught up in the budget process that you forget to keep
doing business.
What Do You Budget?
Many financial budgets provide a plan only for the income
statement; however, it is 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 had already been in
business for a couple of years and were adding a new product line,
you would need to consider the impact of inventory purchases on
cash flow.
Budgeting the income statement only also doesn't allow a
full analysis of potential capital expenditures on your financial
picture. For instance, if you are planning to purchase real estate
for your operation, you need to budget the effect the debt service
will have on cash flow. In the future, a budget can also help you
determine the potential effects of expanding your facilities and
the resulting higher rent payments or debt service.
How Do You Budget?
In the start-up phase, you will 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 are 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 will 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 WinFast.
Yes, this seems like a lot of information to forecast. But it is
not as cumbersome as it looks. 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 will 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 will operate, your competition, potential
demand that you might already have seen, and economic conditions.
For cost of goods sold, you will need to calculate the actual costs
associated with producing each item on a percentage basis.
For operating expenses, consider items such as advertising,
auto, depreciation, insurance, etc. 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-process and finished goods. For inventory, accounts
receivable and accounts payable, you will 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, etc. 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 will want to consider seasonality
factors. For example, most retailers experience heavy sales from
October to December. If your business will be highly seasonal, you
will have wide-ranging changes in cash flow needs. For this reason,
you will 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 will need to prepare the income
statement budgets first, then balance sheet, then cash flow. You
will 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 will
need both income statement and balance sheet numbers.
No matter whether you will budget manually or using software, it
is advisable to seek input from your CPA in preparing your initial
budget. His or her role will depend on the internal resources
available to you and your background in finance. You may want to
hire your CPA to prepare the financial plan for you, or you may
simply involve him or her 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. In future years, your monthly financial statements
and accountant-prepared year-end statements will be very useful in
preparing a budget.
Excerpted from Start Your Own Business: The Only Start-Up
Book You'll Ever Need, by Rieva Lesonsky and the Staff of
Entrepreneur Magazine, © 1998 Entrepreneur Press