Part of being the CFO of your small business is to be able to make sense of the numbers. Only once you can turn your data into usable information can you more effectively plan out your business. Understanding your budget is important because your business must be able to understand how its cash flows in relation to its income and expenses in order for the business to survive.
When trying to figure out how to budget for your business, it is important to understand and distinguish between the various ways types of budgeting variations.
- Projections – Projections consist of both financial and operational numbers which depict what is expected to be possible in the future. Think of a projection as showing the financial outcome based on hypothetical assumptions which are consistent with the purpose of the financial projection but is not necessarily expected to happen. As an example, consider plugging a target destination into a GPS, the projection is the equivalent of considering what would happen if different routes and even perhaps aimed for a different destination or target.
- Budgets – A budget is setting the target of where financials are expected to end up. Budgets consist of both financial and operational numbers which are prepared usually annually by management that depict how the company is expected to perform over the next year. Think of the budget like the destination plugged into a GPS system. The destination plugged into the roadmap is equivalent to the financial target that the business is striving to achieve. Often times, budgets must be presented and approved by the board of directors and a well-structured management compensation plan will be based on the managers’ ability to perform against the budget.
- Forecasts – A forecast paints a picture of how the business will hit its budget, or arrive at its target. In the GPS example, consider the route as the intended pathway to the destination; however, it can become affected in mid-journey by outside factors such as road work, accidents, and bad weather. Forecasts are a way to review the performance of the budget throughout the year. Using frequent forecasts will allow a business to make the necessary adjustments required throughout the year in order to get back on course if the numbers are diverging from the budget. A forecast is a statement about the future of the business and are used by management to help predict the most likely financial outcome.
- Pro forma – Pro forma financial statements are comprised of information from the balance sheet, income statement, and cash flow statement which show the effects of a specific transaction on the historical financial statements of a business prior to the transaction actually taking place. This is useful to demonstrate how things might have been different in the past had the potential events of the future been applied to the past events.
Simply put, a budget is a target which the company aims for while the forecast is what the business actually expects to happen and where the business is going. A financial projection is a useful addition to the business planning process by allowing management to look at alternatives.
Creating a formal annual budget can help any budget to more effectively plan for the future. There are many software programs that can be utilized in order to help a small business owner create the budget and they should include the following reports:
- Budget Overview – This report shows a summary of budgeted amounts for a specific budget.
- Budget vs. Actuals – Compares your budgeted income and expenses to the actual amounts so you can tell whether you’re over- or under budget.
When creating a Formal Annual Budget, here is the general pathway to follow to achieve this:
- Review the following:
- Look at Your Growth History
- Look for Industry Trends
- Look for Help From Your Employees
- Begin with the end in mind
- List Your Projected Expenses, Starting With Fixed Ones
- List Your Expected Variable Expenses
- Enter your projected future revenue
- Follow through.