Some companies simply take the previous year’s budget and update the numbers based on available funds and new goals, while others take on the mindset of creating a war plan that represents numerical battle lines in which their business will fight to succeed in the coming year. Either approach works fine, but by taking the latter, you’re more likely to have an emotional investment in your annual budget and work harder to achieve your company’s goals.
Budgets support your strategic goals and depict competitive environments.
It’s important to keep your budget in mind as the year progresses and rework it as new information becomes available. To do so, however, you must augment the numbers with words. For example, in a forward section, detail the current state of your business, its market, the economy, and the number and nature of your competitors. Explain how your budget supports your company’s mission, values and specific objectives.
Some businesses get quite analytical when it comes to their budgets. They add line-item details for every allocation of funds, including explanations for, say, why staffing funds are set at a certain level and why equipment needs are funded as stated. You might also add supporting indices, such as summaries and analyses of previous years’ budgets. An executive summary can help you and other users of your budget digest the data more easily.
Essentially, your budget shouldn’t consist only of numbers. It needs to spell out your strategic goals and depict the competitive environment in which you’re operating.
There are three primary budget components.
The wider picture surrounding your budget is important, but so are the particulars. So, once your budget is set, keep an eye on a variety of items in light of current circumstances. Generally, a business budget will have three primary components:
1. Balance sheet
This section summarizes your company’s assets, liabilities and (if applicable) shareholders’ equity at a specific point in time. The balance sheet is a barometer of the financial condition of your business. So analyze it when you set your budget — it will help you focus on whether your budget can remain realistic.
For example, if the debt load indicated on your balance sheet is growing at a greater rate than you anticipated, it may be time to make some moves. Cutting discretionary expenses, such as bonuses and travel costs, could get the numbers back in line. You might also pursue refinancing some or all of the debt.
2. Cash flow statement
This document denotes your company’s cash inflows from ongoing operations and external financing and investment sources, as well as its cash outflows for business-activities financing and investments. It’s a critical part of any budget because strong cash flow is essential to the success of any business.
When looking at your cash flow statement and the year ahead, think carefully about asset purchases — both planned and unplanned. Many businesses fall prey to cash shortfalls because cash flow isn’t keeping up with the need to acquire new equipment.
In addition, consider the possibility that your various departments won’t be able to stay within their respective budgets. Such spending variances can also hurt a budget’s effectiveness.
3. Income statement.
This section typically addresses sales, margins, operating expenses, and profits or losses. As the year progresses, be sure to watch out for profit margin creep. If your volume falls off, even by a little bit, it could trigger major profitability problems. When you look at this section of your budget, assess whether this year should be growth or “hold steady” year — or a balance of the two.
Estimating income and sales tax liability
Like many companies, you may maintain a certain amount of cash to cover income and sales taxes for an interim period. During this time, your budget may seem to be in better shape than it really is because you haven’t paid out these funds and are overestimating available cash.
Of course, your tax liability will depend on how much income and sales you generate (as well as your business’s tax bracket). So if you find your company is having a better-than-expected year, watch out. Your cash flow might benefit from all that business, but your tax bill could be higher, too, which could lead to an unexpected spending variance when you pay Uncle Sam.
A path toward a better budget
Whichever approach you and your management team take to creating a budget, it’s smart to review it mid-year and make adjustments if necessary. Doing so can help your chances of achieving your financial goals as well as creating a better budget next year.