If small businesses have learned one lesson during the past nine months, it has been the critical importance of having a system and processes in place to manage and monitor their financial resources to ensure sufficient cash flow to fund ongoing operations, recovery and growth.
A budgeting process is foundational for sound business management, growth and long-term sustainability. Here is a practical five-step budgeting process, which you can implement to make your business more resilient, especially in times of challenging and uncertain economic conditions.
1. Have a Written Plan
The first step in the budgeting process is having a written plan. Like most aspects of an organization, budgeting should be driven by the mission (what we do), the vision (what we are trying to accomplish) and the strategy (the steps to get there).
A strategic plan is simply a tool and road map, which lays out how the organization plans to advance its mission and work toward its vision. Organizations that stay focused on their plan know where to allocate their financial resources and, just as important, where not to spend money.
2. Develop Annual Business Goals
Annual business goals should align with the priorities and initiatives outlined in the strategic plan. These goals should drive the budget so company resources are used to support the organizational strategy. The budget provides the financial resources to achieve its goals.
For example, if a business goal is to achieve a 20 percent growth in online sales, develop a new product or service, or expand its facility, there must be dollars budgeted and allocated for these purposes. Goals should be SMART – specific, measurable, achievable, relevant and time-bound. And there should be accountability for achieving the goals.
3. Develop Annual Budget
Prepare a 12-month projected income statement and cash flow forecast. Some companies also use a rolling 13-week cash flow forecast, especially if the business experiences significant swings in revenue. While profitability is an important measure of success, cash will determine the survival of the business and capacity for growth.
Because a budget or forecast is future-oriented, it is impossible to predict all the variables which may affect the company during the coming year; 2020 is a dramatic illustration of this point. However, a budget can and should be based on sound, realistic, well-informed assumptions. Historical financial performance is usually a good starting point and basis for budgeting.
The forecast should include:
- Projected revenue. This is typically the most challenging area to forecast. Projected growth should reflect organizational goals. (for example, increase sales by 15 percent)
- Fixed costs. Projecting fixed operating expenses involves looking at the monthly predictable costs that do not change and are typically the easiest to accurately forecast. Fixed costs include payroll, rent, utilities, insurance costs, etc. Be sure to account for new hires and include at least a modest increase in fixed costs due to inflation (typically 2-4 percent).
- Variable costs. These are costs that fluctuate from month to month and are usually directly linked to sales. Common variable costs include inventory, direct labor, supplies and shipping. These expense line items can appear on the profit & loss statement under cost of goods or operating expenses. It is important to separate variable from fixed costs to get an accurate picture of your true COGS and gross profit margin when doing analysis. Whether these expenses are categorized under COGS or operating expenses, be consistent.
- Projected costs for projects linked with the goals. For example, if the company aims to increase sales by 15 percent, costs associated with the increased sales (additional staff, marketing, travel, etc) should be included in the budget.
- Every organization should have a pre-tax net income goal to allow sufficient profit margin to be reinvested in the operations and growth of the business (retained earnings), or as returns for the business owner or investors. Healthy profit margins are one indicator of an organization’s strength.
4. Review and Evaluate Results
The owner and/or leadership team should monitor performance by reviewing company financial statements on a monthly basis.
Look at how the company performed in the areas below compared to the budgeted amount, previous period and the same period the previous year (horizontal analysis):
- Income statement – change in sales, COGS, gross profit margin, expenses, net income.
- Balance sheet – change in cash, accounts receivable, inventory, loans or lines of credit, accounts payable, retained earnings.
- Cash flow statement – Change in cash position.
Then, look at the percentage of each component in relationship to the total within that financial report. This ‘vertical analysis’ can often provide even more valuable information than looking at the dollar amounts. For example, each item on the income statement should be stated as a percent of sales. (example: Gross profit margin as % of sales).
For the balance sheet, look at cash, inventory and accounts receivable as a percentage of total assets (example: Accounts receivable as percent of total assets). Items under liabilities and equity should be stated as a percentage of total liabilities and equity (example: Accounts payable as percent of total liabilities + equity).
The company should also look at its performance vs. industry benchmarks at least annually. Be sure you are comparing your company to similar size companies in the same industry (NAICS code). Also, be sure you are getting your industry data from reputable sources such as Bizminer, Vertical IQ or IBISWorld.
Note any significant variances – both in both dollar and percentage amounts. A large percentage change could be insignificant in terms of dollars. Conversely, a small percentage change could mean tens of thousands of dollars over or under budget.
Pay particular attention to those areas that affect cash flow such as accounts receivable days, inventory turnover and short-term debt. The more cash that is tied up in receivables, inventory and debt service, the less cash you have available for running your business.
It is important to understand what is causing the variance and whether it is good or bad for your company. Variances can be due to a variety of factors such as inaccurate budgeting, changes in the economy or local market, changes in costs or more/less efficient operations.
A great method for doing variance analysis is to use dashboards or dynamic spreadsheets. You can use conditional formatting and color coding to zero in on the most important areas.
5. Make Adjustments
Use your variance analysis to make adjustments in your budget where needed and create a more accurate forecast for the remainder of the year.
It is important to go through this process every month, rather than waiting until the end of the year, so there can be course corrections or modifications to the budget if needed.
Good budgeting processes can help develop and advance an organization, while sloppy budgeting and monitoring can affect its longterm financial health and viability.
The beginning of the New Year is a great time to put a disciplined process in place for planning, setting goals, budgeting, monitoring, and making adjustments where needed to make your company more resilient, especially in challenging times.
Finally, make sure you have outside advisors on your team. If you need assistance or have questions, please seek out help from the ND SBDC or another local SBA resource partner such as SCORE, ND Women’s Business Center, or Veteran’s Business Outreach Center of the Dakotas (VBOC).