Budgeting and its practical relevance

When one starts a small business there are two motivating factors: the hope that the business will yield a profit, but more importantly, it is an expression of the owner’s passion – his/her belief that the business will truly benefit society. While this drive is necessary in order to have a successful business, without adequate financial tools, the owner’s pride and joy is doomed to fail.   This is why we aim to equip you with the right tools in terms of budgeting in the following article. This has been an important trend in how we approach business, as seen in our March Newsletter and thus we would like to expose you to the benefits of budgeting in a more explicit way.

BUDGETING

Business budgeting is one of the most powerful financial tools available to you as the small business owner.

The act of budgeting has a number of key benefits:

  • It forces you to think through all the important numbers in your business;
  • It enables you to develop a picture of what your business is going to look like in three, six and twelve months – creating a “visual” of expected financial results;
  • It will help you make better decisions, and improve performance in each area;
  • It will help you to develop an understanding of the internal financial workings of your business;
  • It enables you to set financial goals for sales, expenses and profits;
  • It can help you ensure that there is enough cash on hand to cover direct and fixed expenses even if actual sales fall short of projections;
  • It enables you to take charge of your financial situation, as cash flow is controlled by you, instead of it controlling you.  ;
  • It assists in ensuring investor confidence as a working budget should form an integral part of a company’s business plan; and
  • It is an integral part of a start-up business plan, as a budget should give you an accurate reflection of the viability of your business and its potential.

In essence, budgeting overlaps with planning and managing, including the management of human resources (setting targets and motivation) and financial management.

OVERLAP WITH MANAGEMENT OF YOUR BUSINESS

While going through the process of budgeting, you will find yourself asking the following questions:

What can we cut?  Do we have discrepancies in the budget?  Did the last budget produce a profit?

These are all questions which impact on important decisions that management are required to address, when running a business.

SETTING PERIODS FOR YOUR BUDGET

When forecasting your budget, your time periods should include a short-range month to month plan for at least a period of 12 to 24 months, as well as a long-range plan – to be used for financial statement reporting.  The long-range plan should cover a period of at least three years (or even five years) on a quarterly or even annual basis.

Where your business is seasonal in nature, you may have wide-ranging changes in cash flow needs.  For this reason, you may want to consider seasonality in your cash flow budget rather than take your annual projected year-one sales level and divide by 12.

A BASIC BUSINESS BUDGET CONTAINS FOUR MAJOR NUMBERS:

1.   Projected sales and revenue or “the top line”

The sales or revenue budget is the starting point for the entire budgeting process.  You anticipate sales for the upcoming year by month.  This number should be the result of a complete analysis of your marketing and sales activities, historical data, market research, and economic conditions.  Make sure this figure contains high, medium and low sales estimates.

Where your business involves the production of goods, consider selling price, number of units for each product and build in discounts and provide for returns.  These sales numbers will be critical since they will 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.

2.   Projected operation costs

This part of your budget should include all the costs of operation involved in producing and delivering the product or service to customers.  These may include:

  • The costs of purchasing or producing the product or service;
  • Sales and marketing costs;
  • Administration and operation costs;
  • All fixed, variable and semi-variable costs of business operation;
  • Your final number should include 100 percent of all out-of-pocket expenses necessary to achieve your estimated sales revenues.

Where you are producing goods for sale, plan production for the entire year so that the company will produce enough inventory to meet the units required in the sales budget.  The units will then determine the direct material and direct staff/labour needs for the year.

3.     Total profit or loss from operations for that month

Profit or loss from operations based on the previous two numbers (the projected sales/revenue and operating costs) for each month.

4.     Cumulative total of profits or losses from operations over time

Lastly your budget should reflect the cumulative profits or losses of the company over a period of months – these totals will tell you when your business will break even and begin earning a profit.  The total of losses will tell you how much you may have to borrow or inject into the business before it is profitable.

THE PROCESS

Compare income statement budgets first – you need to know the net income figure before you can prepare the pro forma balance sheet because the profit number must be plugged into retained earnings.

Then prepare the balance sheet budget – consider each specific item in fixed assets – for fixed property, equipment, investments, etc.  On the liability side, break down each bank loan separately. Do the same for the shareholder’s equity, and retained earnings.

Then do a cash flow projection – you will need both income statement and balance sheet projections in order to create your cash flow budget.

POWERFUL RESULTS ANALYSIS

There are three main questions to powerful results analysis.  At the end of each month, with budget comparisons in hand, ask your team these key questions:

  • How are we doing compared to budget?  Why did actual results differ from the plan?
  • What must we do now to have a better result next month?  How can we keep the positive differences and avoid more of the negative ones?
  • What are we learning that will make next year’s budget better?

Due to the importance of the budgeting process, we understand that you might see this as a daunting task – which is why we are here to guide you through the process. Arnold Scholtz would like nothing more than to help you translate your passion into a profitable enterprise and you can contact him on 021 840 1600 or send him an e-mail on arnold@asl.co.za. We have also provided a free survey that will indicate to you whether or not you are on your way to turning your small business into a revered company, all you need to do is follow this link. Please register if you have not registered before.

This article was partly reproduced under copyright from Profmark Online Advisor.

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