In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors discuss the basics of creating a projected budget for your first year in business.
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 you're 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 long-range, quarter-to-quarter plan of at least three years that 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-term budget should be updated when the short-range plan is prepared.
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 had 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 future, a budget can also help you determine the potential effects of expanding your facilities and the resulting higher rent payments or debt service.
In the startup 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 1?
- 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 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. Yes, this seems like a lot of information to forecast. But it’s 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'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'll 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, 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-progress, 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 2 and 3. 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 so you'll want to consider seasonality in the budget rather than take your annual projected Year 1 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. Their 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 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.