Budgeting

Business budgeting is one of the most powerful financial toolsavailable to any small-business owner. Put simply, maintaining agood short- and long-range financial plan enables you to controlyour 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 along-range, quarter-to-quarter plan you use for financial statementreporting. It should be prepared during the two months precedingthe fiscal year-end to allow ample time for sufficientinformation-gathering.

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

While some owners prefer to leave the one-year budget unchangedfor the year for which it provides projections, others adjust thebudget during the year based on certain financial occurrences, suchas an unplanned equipment purchase or a larger-than-expected upwardsales trend. Using the budget as an ongoing planning tool during agiven year certainly is recommended. However, here is a word to thewise: Financial budgeting is vital, but it’s important to avoidgetting so caught up in the budget process that you forget to keepdoing business.

Many financial budgets provide a plan only for the incomestatement; however, it’s important to budget both the incomestatement and balance sheet. This enables you to consider potentialcash-flow needs for your entire operation, not just as they pertainto income and expenses. For instance, if you’d already been inbusiness for a few years and were adding a new product line, you’dneed to consider the impact of inventory purchases on cashflow.

Budgeting only the income statement also doesn’t allow a fullanalysis of the effect of potential capital expenditures on yourfinancial picture. For instance, if you’re planning to purchasereal estate for your operation, you need to budget the effect thedebt service will have on cash flow.

In the startup phase, you’ll have to make reasonable assumptionsabout your business in establishing your budget. You will need toask 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 bepriced?
• How much will it cost to produce your product? How muchinventory 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? Whatwill your payroll and unemployment taxes be?
• What will the income tax rate be? Will your business be an Scorporation or a C corporation?
• What will your facilities needs be? How much will it cost youin rent or debt service for these facilities?
• What equipment will be needed to start the business? How muchwill it cost? Will there be additional equipment needs insubsequent years?
• What payment terms will you offer customers if you sell oncredit? What payment terms will your suppliers give you?
• How much will you need to borrow?
• What will the collateral be? What will the interest ratebe?

As for the actual preparation of the budget, you can create itmanually or with the budgeting function that comes with mostbookkeeping software packages. You can also purchase separatebudgeting software such as Quicken or Microsoft Money.

The first step is to set up a plan for the following year on amonth-to-month basis. Starting with the first month, establishspecific budgeted dollar levels for each category of the budget.The sales numbers will be critical since they’ll be used to computegross profit margin and will help determine operating expenses, aswell as the accounts receivable and inventory levels necessary tosupport the business. In determining how much of your product orservice you can sell, study the market in which you operate, yourcompetition, potential demand that you might already have seen andeconomic conditions. For cost of goods sold, you’ll need tocalculate the actual costs associated with producing each item on apercentage basis.

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

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

Consider each specific item in fixed assets broken out for realestate, equipment, investments and so on. If your new businessrequires a franchise fee or copyrights or patents, this will bereflected as an intangible asset.

On the liability side, break down each bank loan separately. Dothe same for the stockholders’ equity–common stock, preferredstock, paid-in-capital, treasury stock and retained earnings.

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

As for the process, you need to prepare the income statementbudgets first, then balance sheet, then cash flow. You’ll need toknow the net income figure before you can prepare a pro formabalance sheet because the profit number must be plugged intoretained earnings. And for the cash-flow projection, you’ll needboth income statement and balance sheet numbers.

Whether you budget manually or use software, it’s advisable toseek input from your CPA in preparing your initial budget. YourCPA’s role will depend on the internal resources available to youand your background in finance: You may want to hire a CPA toprepare the financial plan for you, or you may simply involve themin an advisory role. Regardless of the level of involvement, yourCPA’s input will prove invaluable in providing an independentreview of your short- and long-term financial plan.