Finance Essentials: Budgeting

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Budgeting and forecasting – a lot of entrepreneurs are discouraged the moment they hear about it. It sounds like an impossible task to predict the future and often is overlooked because of its complexity. Of course, how could it be possible to say: “By the end of next twelve months I will earn $ X  income and generate $ Y cash.”? Actually you just need a little change in perspective and you will start seeing your operating budget more like map towards your targets, and your key drivers showing your way to your targets. Lets take a look at the budgeting and forecasting process in the article below, to make it clear for you.

As we agreed in the beginning it is difficult to predict exactly the future. Of course there are uncertainties and variables, but it is at utmost importance to frame out your targets for the upcoming periods so you know where your company is headed. When you are looking for ways to expand and grow your business, your best option will be to put your company’s goals in a plan which will show your potential opportunities and/or bottlenecks in advance. This will help you to take the important decisions needed while leading your company towards these goals. Yes, things will not always work out as expected, but having detailed plan to follow will give you the flexibility to adjust your operations and on to get back on track to your targets.

The financial measurements of success for your business will be your company’s profitability and generated cash, so the financial expression of your goals will be through the three main corporate financial statements – Income Statement, Cash Flow and Balance Sheet. The usual time frame for your operating budget would be the following 12 months. Sound plan should be build with your historic financial results  as a starting point, but they should not be limiting if a higher growth could be reasonably expected for example. If you are in a startup business and you are missing previous data, you should base your plan on your projects and market research, using similar businesses for reference. In this case you might not get into great details in the beginning, but you will gain the additional information later on, in the process of managing your business.

The starting point for your operating budget should be your key projects and drivers for your company growth – your sales. You should build a really detailed and sound sales forecast, including your upcoming projects, price strategies, route to market, attracting and retaining customers etc. So if we assume that your key driver is to build 3 different products A B and C  for example, and sell 100 pieces of each,  for prices respectively Pa Pb and Pc. Then your sales forecast will look like that:

This will be the top line from your income statement.

Now you have to plan the cost of your sales. Here you will include your raw materials, direct labor, shipping costs and depending on your business type any costs directly involved in producing a product or delivering a service. So in our case products A B and C direct costs will form cost of sales:

So far you budgeted your income statement down to your gross profit line.

Next step is to forecast all the costs that are related with your business operations. These are the costs behind the people who work for your marketing and sales programs and drive the sales, administrative support, rent and utilities of your office and everything else that could be related to your day-to-day business activities.

Having all your operational expenses summed up, you already have forecasted your operational income for the budgeted period.

Estimating the corporate income tax and interest costs will get you to your net income line of your forecast. With this you have complete Income Statement for the budgeted period. Now you have successfully budgeted your company’s profitability.

Your next step will be to forecast the cash you will generate. To do that you will need to estimate several lines from your balance sheet.

The period for which you collect sales payments from your customers and the period for which you pay your suppliers will give you respectively your accounts receivable and accounts payable. For the simplicity of this example, we assume that you sold all the inventory that you built up during the period or that you do not have any inventory. With this information you could forecast your cash flow from operations.

Adding your estimates for capital expenditures, raising or paying debt and change in equity will give you the ability to budget your cash flow all the way down to the net cash.

So now you have forecasted your business’ profitability and the cash it will generate. But the work has only just began – you have to start monitoring your quarterly, even better monthly results and readjust your plan for the variables that will show up along the way. Rather than one-time exercise, forecasting will be a continuous process, especially in the beginning, while you are still missing stable historical data to use as a base of your budgets.

This is a lot of information and work to be done, but once you get the processes down, for putting your operating budget, it will bring enormous results for you and will help you manage your business more effectively.

If you need some help on getting started with your financial planning, you can check out our Complete Financial Planning and Analysis model below.

Advanced Model

If you are not ready to create a complete financial forecast for your company, prepare only sales forecast instead in the beginning. This is a simple, but yet very important step for managing your business effectively!

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