Failing to plan is planning to fail, that is why budgeting can help a business achieve financial success, predict profitability, provide a model for performance, formulate plans and strategies, and forecast income and expenditures.
Planning and Forecasting
A budget provides insight into a company’s financial position for the near future. A budget is a tool for planning and performance metrics. CEOs and CFOs can budget ahead by setting up incentive or educational plans for employees, buying equipment and assets, launching new product lines or services, etc.
Management and Decision Making
Leadership and management can use budgeting as a tool to control expenditures, evaluate plans and make better decisions when unexpected changes occur as budgeting provides a reference and framework for decision making.
Measurement of Business Performance
Budgeting provides metrics to measure as well as monitor actual business performance in comparison with expected business performance.
“Variance” is the difference between budgeted expenditures and actual expenditures. A prime use of the budget is as a performance baseline for the measurement of actual results. It can be misleading to do so, since budgets typically become increasingly inaccurate over time, resulting in large variances that have little basis to actual results. To reduce this problem, some companies periodically revise their budgets often to keep them closer to reality. As businesses are dynamic and continually changing, budgeting is always predicting moving targets. Business owners and financial managers should keep in mind that budgeting is not a static process but rather a dynamic process.
Budget and Business Reality
The budget should develop sets of reasonable and attainable goals for the firm, using data and assumptions based on historical results, management insight, and knowledge of upcoming internal and external events or influences. For example, a sales budget tells employees what their sales targets are, and by when they’re expected to achieve them.
Companies often have a “master” budget that captures the financial targets for its entire operation. In addition, a firm may develop more detailed budgets at a secondary level. Depending on its needs and complexities, a firm will formulate the additional, detailed budgets it needs to fine-tune the targeted revenues and expenses for more complex areas of the business.
The three most important types of budgeting
The three most important types of budgeting that many business firms focus on include operating budgeting, capital budgeting, and cash flow budgeting. Other budget areas exist but these three establish a detailed foundation.
The operating budget, formatted as an income statement, is built up starting with the firm’s sales forecast. The budget of sales revenue minus cost of goods and selling, general, and administrative expenses essentially ends up at net profit. In the operating budget, determine what you need in sales revenue and the expenses the company will incur to support that level of sales while also achieving your profit goal.
Capital budgeting creates a plan for the large expenses in a firm. Capital budgeting illustrates the fixed assets that the firm predicts it needs to invest in, such as new buildings or expensive equipment. It is the process of budgeting or estimating the costs to obtain, expand, and replace fixed assets. Having an accurate budget for large, expensive assets with multi-year lives like buildings, equipment, tools, and similar assets is important because of the large monetary investment and the life of these types of assets. If you make a mistake in capital budgeting, it could haunt you for a long time.
Cash Flow Budget
The cash flow budget shows expected cash inflows (receipts or sources) and cash outflows (expenses or uses). The cash flow budget shows whether the company will have enough cash to continue meeting its monthly expenses over the budgeted time period. If not, the cash flow budget can reveal when to borrow and how much, if you don’t have enough money to meet expenses.
Most business owners start out with budgets that project income and expenses to establish the company’s income statement. But other types of budgeting are also necessary for a company. For example, you also need to project the level of assets and liabilities you expect to have in the future, as shown on a firm’s balance sheet
Regarding the statement of cash flows, it is particularly important to include this in budgeting. Projecting cash flows is very important to ensure that the company is always in a positive cash flow position and can meet its short-term debt obligations. If you can develop good financial budgets, you can have more control over your cash flow, which is vitally important to your business firm so it can pay its bills in a timely manner.
At a2z CFO, we help companies with budgeting and many other types of CFO services, to “keep your ship on course.”