Building A Financial Budget Creating a financial plan lets you control your business's cash flow...instead of it controlling you.
For many small-business owners, the process of budgeting islimited to figuring out where to get the cash to meet nextweek's payroll. There are so many financial fires to put out ina given week that it's hard to find the time to do any short-or long-range financial planning. But failing to plan financiallymight mean that you are unknowingly planning to fail.
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-rangemonth-to-month plan for at least a calendar year and aquarter-to-quarter long-range 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 is important to avoidgetting so caught up in the budget process that you forget to keepdoing business.
What Do You Budget?
Many financial budgets provide a plan only for the incomestatement; however, it is 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 had already been inbusiness for a couple of years and were adding a new product line,you would need to consider the impact of inventory purchases oncash flow.
Budgeting the income statement only also doesn't allow afull analysis of potential capital expenditures on your financialpicture. For instance, if you are planning to purchase real estatefor your operation, you need to budget the effect the debt servicewill have on cash flow. In the future, a budget can also help youdetermine the potential effects of expanding your facilities andthe resulting higher rent payments or debt service.
How Do You Budget?
In the start-up phase, you will 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 are 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 will 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 rate be?
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 WinFast.
Yes, this seems like a lot of information to forecast. But it isnot as cumbersome as it looks. The first step is to set up a planfor the following year on a month-to-month basis. Starting with thefirst month, establish specific budgeted dollar levels for eachcategory of the budget. The sales numbers will be critical sincethey will be used to compute gross profit margin and will helpdetermine operating expenses, as well as the accounts receivableand inventory levels necessary to support the business. Indetermining how much of your product or service you can sell, studythe market in which you will operate, your competition, potentialdemand that you might already have seen, and economic conditions.For cost of goods sold, you will need to calculate the actual costsassociated 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 basedon actual business tax rates that you can obtain from youraccountant. 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, accountsreceivable and accounts payable, you will 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, etc. If your new business requiresa franchise fee or copyrights or patents, this will be reflected asan intangible asset. On the liability side, break down each bankloan separately. Do the same for the stockholders'equity-common stock, preferred stock, paid-in-capital, treasurystock and retained earnings.
Do this for each month for the first 12 months. Then, preparethe quarter-to-quarter budgets for years two and three. For thefirst year's budget, you will want to consider seasonalityfactors. For example, most retailers experience heavy sales fromOctober to December. If your business will be highly seasonal, youwill have wide-ranging changes in cash flow needs. For this reason,you will want to consider seasonality in the budget rather thantake your annual projected year-one sales level and divide by12.
As for the process, you will need to prepare the incomestatement budgets first, then balance sheet, then cash flow. Youwill need to know the net income figure before you can prepare apro forma balance sheet because the profit number must be pluggedinto retained earnings. And for the cash flow projection, you willneed both income statement and balance sheet numbers.
No matter whether you will budget manually or using software, itis advisable to seek input from your CPA in preparing your initialbudget. His or her role will depend on the internal resourcesavailable to you and your background in finance. You may want tohire your CPA to prepare the financial plan for you, or you maysimply involve him or her in an advisory role. Regardless of thelevel of involvement, your CPA's input will prove invaluable inproviding an independent review of your short- and long-termfinancial plan. In future years, your monthly financial statementsand accountant-prepared year-end statements will be very useful inpreparing a budget.
Excerpted from Start Your Own Business: The Only Start-UpBook You'll Ever Need, by Rieva Lesonsky and the Staff ofEntrepreneur Magazine, © 1998 Entrepreneur Press