Any business needs a Budget to foresee where it is going on a financial point of view. Running a business without a budget is like flying a plane without calculating how much fuel you need to get to your destination: You might be lucky, but you also have a large probability of crashing!
A budget is the dollar representation of your plan for the referred period. It is done for a full year, preferably showing each individual month for greater accuracy.
The process is simple:
· Set specific targets in terms of sales, production and distribution (In units or $);
· Quantify in dollar values the revenues, cost of sales and expenses;
· Consider the capital expenditures (Purchase of equipment or other assets), if any;
· Do not forget to account for other cash movements such as financing, taxes, etc.
The above will allow you to draft three statements:
· A Budgeted Profit & Loss (Revenues, cost of sales and all overheads such as rent, telephone, wages, etc.)
· A Cash Flow forecast (The timing effect of all income and expenses, plus the Capital Expenditures, plus the changes in financing)
· A Budgeted Balance Sheet (Assets and Liabilities)
The three above statements are connected with each other: Any change in one will have repercussion(s) in the other(s).
The easiest way to do a budget is to begin with the last known Profit & Loss and adjust for foreseeable changes: Figures should be adjusted for changes in Sales, Cost of Materials, Energy costs, Insurance, Rent, Telephone, Wages, etc.
Once you have your new Profit & Loss statement, preparing the Cash Flow forecast and the Balance Sheet is easy.
If you feel confident, you may chose between the different ways to prepare a P&L budget:
1. Using the last known one and adjusting for changes starting with Revenues (This is traditional budgeting);
2. Using information from the last known one and starting adjusting the Profit before Tax line all the way up to Revenues (This is traditional budgeting with the emphasis on Profits);
3. Starting with a clean blank sheet and beginning with Revenues, all the way down to Profit (This is known as “zero based budgeting”);
4. Starting with a clean blank sheet and beginning with Profit before Tax all the way up to Revenues (This is another variant of the “zero based budgeting”.
Okay: Your initial budget is ready.
You can now either keep it as it is or play with different scenarios and see the impacts.
Last but not least, the objective of a budget is not to be stored in the bottom drawer: It needs to be compared regularly against actual figures. If the actual figures come close to the budget, everything is fine and you know where your business is financially heading. But if actual figures differ widely from the budget, something is wrong and either corrective action needs to be taken immediately or the budget needs to be revised.
If you are on top of your budget, you are in control of what is happening in your business and where it is heading.