Entrepreneurial Tip Corner: Establishing a Budget
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The first time a company tries to go through the budgeting process is always the most difficult. Some numbers may come from good historical data and recent trends while other numbers may come out of the CEO’s back pocket. It really doesn’t matter. Let me repeat that statement: It really doesn’t matter. It doesn’t matter where the budget information comes from because establishing a budget is simply step one of the budgeting process. This budget will act as a guideline for the year.
Once the budget is established, you then need to compare the actual results of operations to the budgeted numbers on a monthly basis and try to analyze the reasons for being either over or under the budget by a significant percentage for each item of income and expense. You should learn to recognize what is simply a timing difference in income and expenses versus a permanent difference. For example, a customer delays an order from one month to the next because they were on vacation. This order will still result in the same amount of revenues for the year, but may appear one month later than budgeted. This is a timing difference. If however, this customer is now buying from your competitor, or has gone out of business, you will permanently lose these revenues, which is a permanent difference.
You should also try to perceive trends in income and expense items, and take appropriate action as a result of such trends. One example is if you notice a trend of declining revenues with a product or service. You should be asking several questions as a result of this observation. Have market circumstances recently changed causing this trend? Is the marketing team effectively marketing this product or service? Is the sales team equally motivated to sell this product or service? Can any action be taken in either marketing or sales to reverse this negative trend? If not, should this trend simply be accepted with nothing done about it, or perhaps should replacing, improving, updating or even discontinuing this product or service be examined? If this trend is ultimately accepted and the top-line revenue forecast adjusted accordingly, how will this affect the bottom line for the year? If it will result in a loss for the year, should additional steps be taken to cut costs to reduce the loss? Is the entire sales force needed to bring in significantly less revenues? No matter what action is taken, the forecast for the rest of the year should reflect the new assumptions in place, based upon the actions taken.
Thus far, we have talked about budgeting and forecasting the profit and loss statement (P&L). It is equally critical to budget and forecast the cash flows, which is a function of the monthly P&L and balance sheet budgets. Understanding how accelerating the collection of your receivables or extending the number of days in which you pay your bills affects your cash flows is very important. Increase your cash available by collecting your receivables more quickly. Similarly, if you delay paying your bills by a few days, you will increase your cash available. Be careful if you choose this tactic however, as you may adversely affect your business credit rating.
Why is it so important to forecast a business’ cash flows? If a business is not forecasting its cash flows, it will not properly be prepared for times in which cash is tight. If on the other hand, a forecast is prepared which reveals, for example, that in three month’s time the business will have a short-fall and need cash, steps can be taken ahead of time to either secure cash through borrowing and/or putting actions in place to accelerate the collection of receivables or delay payables (with advanced communication to vendors so they are not blind-sided). This is particularly important during periods of growth, when a business needs additional working capital (cash) to sustain a higher level of accounts receivable as it increases its revenues.
Business planning is an essential part of managing your business, and the budget process is a key component of business planning. Good business planning should provide solutions to daily problems that will occur and be able to lessen their impact or avoid them altogether. This should result in less crisis management and stress, and better productivity.
--Michael Herz, CPA, MBA