Running a small business can be both rewarding and challenging. According to U.S. Chamber of Commerce, 54% of small business owners grapple with inflation worries, while fluctuating revenue, shifting interest rates, and supply chain issues are other major causes of concern.
But perhaps the most daunting worry for entrepreneurs is the fear of failure. The U.S. Bureau of Labor Statistics shows that, from 1994 to 2023, over 20% of new businesses fail within their first year. While several factors contribute to this, strategic financial decision-making and daily financial management are key.
In this article, we will explore how budgeting can push for small business growth and how businesses can create a business budget that works for them.
Why is it Important to Create a Business Budget?
Creating a small business budget maximizes efficiency and establishes clear financial plans. It plays a large role in cash flow forecasting and preparing for slower business periods, ensuring spending is strategically aligned with business objectives. A well-structured business budget sets specific goals, strategies, measures, and targets while effectively managing fixed and variable costs. In short, a business budget creates a financial roadmap for small businesses to make profits and achieve success.
Exploring Different Types of Business Budgets
Before we delve into how to create a business budget, let’s explore various types of budget that serve distinct purposes in business financial management:
- Master Budget: This comprehensive overview combines multiple smaller budgets, providing a complete financial outlook of the business, including income, expenses, cash flow, and capital expenditures.
- Operating Budget: Focused on the day-to-day operations, this budget details expected revenue and expenses, guiding short-term business decisions.
- Cash Budget: Essential for cash flow management, it tracks the inflow and outflow of cash, ensuring sufficient liquidity for operational needs.
- Static Budget: A fixed budget for a specific period, not changing despite variations in business activity, useful for stable environments.
- Departmental Budget: Allocated to individual business departments, this budget helps manage expenses in specific areas, aiding in resource allocation and performance evaluation.
Each type plays a role in managing resources, maximizing assets, and enhancing revenue streams.
Important Formulas to Consider During Business Budgeting
There are basic accounting formulas that are essential in assessing a company’s financial health in business budgeting. These calculations, such as gross profit, net profit, and return on investment (ROI), offer insights into current performance. Understanding these metrics helps businesses set realistic goals and shape future budgets, aligning with long-term objectives and strategies.
Gross profit is calculated by subtracting the cost of goods sold (COGS) from gross revenue, both found in the income statement. COGS should include only direct expenses related to producing a product or service, such as materials and labor, and exclude indirect costs like rent or marketing. This calculation provides insight into the efficiency of production and sales processes.
Net profit is determined by deducting operating expenses and taxes from gross profit. It’s a metric reflecting the overall profitability of a business. Companies often allocate net profit into various categories based on priorities and needs, such as reinvestment in the business, debt repayment, expansion projects, and building emergency funds.
Return On Investment
Return on Investment (ROI) is a key performance indicator calculated by dividing the net profit from an investment by its cost. It’s used to measure the efficiency and profitability of investments, guiding businesses in making informed decisions. A higher ROI indicates a more profitable investment, which is essential for strategic financial planning.
Break Even Point
The Break-Even Point is calculated to determine when a company will start to make a profit. It involves fixed costs (costs that don’t change with production volume), variable costs (costs that vary with production), sales price per unit, and the contribution margin (sales price per unit minus variable cost per unit). The formula is Break-Even Point = Fixed Costs / Contribution Margin. This calculation is essential for assessing a company’s profitability and financial health, indicating the sales volume needed to cover all costs.
8 Steps to Create A Budget For Your Business
When wondering how to create a budget for a small business, there are several key steps. From setting clear goals to analyzing past financial records, each step is designed to provide a comprehensive and realistic financial plan.
1. Setting Goals and Objectives
Setting concrete goals and objectives is fundamental in budgeting. Utilize your company’s profit, ROI, and break-even analyses to establish clear targets for future sales, net profit, and ROI. Employ SMART goals – Specific, Measurable, Achievable, Relevant, and Time-bound – to ensure financial resources are utilized efficiently and objectives are attainable. This approach helps set practical targets and align them with your business’s broader strategic plan, ensuring a focused and effective path to financial success.
2. Estimating Revenue Projections
Estimating revenue projections requires a careful analysis of past and current market trends. Begin by reviewing the previous year’s revenue figures to establish a baseline. Conduct thorough market research to understand pricing dynamics and sales volume potential. Leverage historical data to identify patterns and predict changes for the upcoming year. Consider factors like potential pricing adjustments, anticipated changes in sales volume, and overall market growth. These considerations help create realistic and informed revenue projections, which are important for effective budget planning and management.
3. Assessing Expenses and Costs
In budgeting, understanding and categorizing expenses is your first step. Expenses typically fall into three categories: fixed costs, variable expenses, and one-time spending. Fixed costs, like rent or salaries, remain constant regardless of business activity. Variable expenses, such as raw materials or utility costs, fluctuate with the level of production or services provided. One-time expenditures can include buying new equipment or initial marketing campaigns.
Variable costs require careful analysis. For instance, if production increases, raw material costs will rise proportionately. Conversely, during slow periods, these costs can decrease.
Cost-cutting can significantly affect financial metrics. Reducing variable costs can lower the cost of goods sold, thus improving gross and net profit, and positively impacting the break-even point. During slow sales periods, minimizing variable costs can help maintain profitability, whereas in good sales periods, increased spending in this area can support growth and meet higher demand. Balancing these costs in line with business cycles is key to effective financial management.
4. Analyzing Past Financial Statements and Records
Analyzing past financial statements, including income statements, balance sheets, and cash flow statements, is a good start for your budgeting process. This review helps identify trends and performance patterns, revealing areas of budget surpluses or overspending. Examining past expenses can also offer insights into spending patterns and highlights cost structures that might have gone unnoticed. This granular insight enables you to make informed decisions during the budget creation, ensuring that financial allocations align with your business’s strategic goals.
5. Determining Cash Flow Requirements
Determining cash flow requirements involves evaluating accounts payable and receivable, alongside projected cash inflows and outflows. Utilize your income statement and turnover rates to develop a detailed cash flow statement. This document is essential for monitoring the cash required to sustain daily operations and meet financial obligations. Regularly tracking cash flow helps in maintaining adequate liquidity. In scenarios of temporary cash flow issues, consider options like short-term funding to bolster working capital, ensuring smooth and uninterrupted business operations.
6. Developing an Emergency Fund Plan
Developing an emergency fund plan is a big part of financial planning. Begin by determining the fund’s purpose, typically to cover unexpected costs such as equipment repairs, sudden market changes, or unforeseen operational expenses. A general guideline is to save enough to cover 3-6 months of operating expenses. Assess your regular expenses to calculate this amount accurately. A contingency fund can help with financial security, providing a safety net during unforeseen events, as many potential scenarios need this fund – including sudden market downturns, emergency repairs, or unexpected legal fees.
While preparing a budget, identify the strategy to save for the emergency fund and highlight the areas of cost cutting to build this fund. If you can’t make room for emergency expenses in your budget, outline the external source of funds such as emergency business loans that you can utilize to cover unexpected costs.
7. Defining Time Period for the Budget
When setting a budget, clearly define its time frame. Short-term budgets, typically monthly or quarterly, allow for close monitoring and quick adjustments to changing business conditions. They are particularly useful for managing cash flow and operational expenses. Long-term budgets, usually annual, are essential for strategic planning and long-range financial goals.
Both quarterly and annual budgets have their merits, though; quarterly budgets offer flexibility and frequent reassessment opportunities, while annual budgets provide a broader view for long-term financial planning. Implementing an “actual budget” helps compare estimated figures with actual results, enabling necessary adjustments to align short-term actions with long-term objectives. Regular reviews and updates of short-term budgets are crucial to keep the long-term budget on course and aligned with evolving business strategies.
8. Utilizing a Template or Software to Organize Your Business Budget
Utilizing a business budget template or software is an efficient way to organize your finances. Templates offer predefined frameworks and formulas, simplifying the budget creation process, especially for beginners. With analytical and predictive capabilities, modern budgeting software can analyze past data to identify trends and project future revenues and cash flows. This technological aid enhances accuracy and foresight in financial planning. Popular tools among small businesses include QuickBooks for comprehensive financial management, Microsoft Excel for versatile budgeting templates, and FreshBooks for streamlined invoice and expense tracking.