How to prepare a budget
Creating a budget for your business is a vital component of your business plan. Forecasting income and expenses will help business owners align their business plan and strategic objections to financial outcomes.
What is a budget?
A budget is a forecast of business income, expenses and other payments and receipts. The budget should be organised in a way which readily determines the business’ profit and loss, capital expenditure, working capital, cash and debt requirements.
They can be simple or complex and can either be presented in a simple profit and loss format or as a three way Cashflow, Balance Sheet and Profit and Loss Statement. The latter is more effective and complete in allowing a business owner to assess cash, profit and value. If this is the first time you are preparing a budget, start with something simple and work your way up from there.
A budget can be prepared on a daily, weekly, monthly, quarterly or annual basis. Most are prepared for monthly reporting and consideration.
Why produce a budget?
It is simple, if you can't measure it - you can't manage it.
The budget is a financial representation of the business plan. It is the financial outcome of the business strategic direction and initiatives implemented to achieve business plan objectives.
The budget will enable the business to measure the performance and the ultimate success of the business by comparison of actual results against desired (budgeted) outcomes.
At the very least a budget should enable a business owner to plan for and identify cash shortfalls and/or business losses which may require a change in strategy.
For instance, you may be budgeting for a loss in April. There may be a reason for that and that might be okay given the circumstances. It may also be the case that you could change a strategy initiative to counteract the loss. For example, you could increase your marketing spend at this time to increase sales or reduce staff hours to cut costs for that month.
A budget will also act as a measure to control costs by a comparison of actual costs to what was budgeted.
Who prepares the budget?
Creating a budget is a team effort and all senior stakeholders need to be involved in the budget to make it as accurate as possible. If you have a CFO, he/she would normally prepare the budget with input from the sales team, operations team, HR and the business owners. If you do not have a CFO, the budget should be a joint effort with input from across the business.
When do you prepare a budget?
For a new business, the budget should be prepared before you go live. For businesses that already exist, the budget should be finalised before the commencement of the new financial year. It is common for the budget process to commence in April with finalisation and board approval (if needed) by 30 June each year so that the budget is ready to be implemented and reported on 1 July.
How do you prepare a budget?
- Quantify sales – by unit and value.
- Quantify cost of sales – cost of sales includes purchases and other costs incurred in bringing the item into use. This can include a portion of labour and on costs.
- Identify and categorise overhead costs – common categories are sales and marketing, occupancy costs such as rent and rates, finance costs, HR and people costs such as salaries, payroll tax and superannuation. Don’t forget your administration costs which usually include the remainder items such as office stationery, legal costs, insurance, etc.
- Fixed costs – it is important to identify those overheads and costs of sales that are fixed costs. This is critical so that you can determine the business break even sales point.
- Other payments – identify other payments such as income tax, loan repayments, capital expenditure and dividend payments.
- Make assumptions – identify assumptions such as gross profit percentage, Trade Debtor and Trade Creditor Terms. This will impact your cash flow.
- Profit and loss – adopt a template that will show a budgeted profit and loss statement, balance sheet and statement of cash flows.
- Test – test the budget assumptions. Is the gross profit percentage realistic? How do the expenses compare to last year? Are changes to past year expenses in line with strategy initiatives?
- Strategy – remember that the budget is a key part of your business plan and strategy and the two should be aligned. Challenge the budget. Do the financial results reflect reality and are the results and cash flow achievable?
- Measure Key Performance Indicators (KPIs) – common KPIs include gross profit percentage, profitability percentage, breakeven sales, debtor’s days outstanding, creditor’s days outstanding, stock days, current ratio, debt to equity and return on capital employed.
- Benchmark – compare the financial KPIs with industry benchmarks.
It is important that the budget is achievable and is stress tested for best and worst case scenarios. You’ll need to consider:
- What happens if you do not achieve sales targets?
- What is the impact on cash, profit and ultimately, the business value?
- What do you need to do to achieve the best case budget?
When preparing your budget be flexible and be real. Be honest in your assessment of sales and expenses.
Budgets and business plans are often prepared and then never see the light of day.
It is important that business owners meet and report on financial results on a monthly basis. Consider the below at each meeting:
- Financial results
- Sales and marketing
The management team members should each report on their area of concern.
The CFO or business owner’s report should include:
- The profit and loss with a variance analysis to budget for the month and year to date
- Commentary on the major variances, forecast cash flows and any working capital and or debt issues arising
- Compliance with regulatory authorities. Are tax lodgements up to date and taxes paid? Has superannuation been paid?
- Are bank covenants being satisfied?
- Is the business adequately insured?
How are you tracking?
If you are not achieving the financial results you desire, you’ll need to go back to your business plan and check your strategy and initiatives. Are you implementing the initiatives you said you would? Do the initiatives work? What do you need to change to achieve results?
- Keep it simple.
- Achieve profit targets.
- Manage your working capital.
- Cash is still king.
Remember, the budget is there to help you achieve your business goals.
Challenge the status quo, look for efficiencies and if in need, seek help.