Financial budgeting
Every business or organization should consider the importance of having a financial budget.
For instance, look at the financial budget as a roadmap leading to a destination. A detour without a course correction can lead to a delay in arrival or worse, not arriving at all.
The financial budget has planned expenditures and projected revenue. If a detour occurs, such as lost revenue or an increase in expenses, owners and managers can use the budget to help decide what to adjust.
So, the Merriam-Webster online dictionary defines a financial budget being “a plan for the coordination of resources and expenditures.”
Business planning, strategic planning, and cost accounting all use financial budgets. Budgeting is also critically important in a startup business.
A regular budget is for a set period. A rolling budget is continually updated, so there is always a budget for the next twelve months.
The importance of a budget
The budget creates a plan for cash flow. Consequently, having a positive cash flow provides the ability to pay for inventory, expenses, and debt service.
As a result, companies that operate with a budget get in the mentality of planning their expenditures. Without a budget, they are never sure if they have enough money.
Cash flow projections
The financial budget starts with an income statement by account, then a balance sheet. And subsequently, a cash flow statement.
A budget to actual variance is the difference between the company’s budget and actual results. Therefore, owners and management look for potential changes by studying the variance reports.
Banks and lenders depend on financial budgets
Banks, finance companies, and equipment manufacturers are always looking for new customers. As a result, they require different levels of detailed analysis that provides evidence the company is on solid financial footing.
Similarly, the lenders may require a budgeted income statement and balance sheet with projected cash flow.
The budgeting process
The budgeting process starts with the income statement.
Determine the production process and calculate revenue, cost of revenue, operating expenses, other income/expenses, and non-cash expenses such as depreciation and amortization.
The income statement in a financial budget
Moreover, the income statement is the starting point for calculating the budget.
Income should be based on revenue by customer and product mix.
Revenue and cost of goods sold
This chart is an example of the revenue and cost of goods sold for three different items. Each item has a different gross profit percentage.
In short, Increases or decreases in revenue can cause changes in the product mix and to the net income and cash flow.
| Item A | Item B | Item C | Total | |
|---|---|---|---|---|
| Revenue | $1,000 | $500 | $250 | $1,750 |
| Cost of Goods Sold | ||||
| Item cost | $750 | $200 | $100 | $1,050 |
| Gross Profit | $250 | $300 | $150 | $700 |
| Gross Profit Pct | 25.0% | 60.0% | 60.0% | 40.0% |
Cost of goods sold could be for a manufactured item or an item that is purchased and resold.
Manufactured items
The manufactured cost includes
- equipment
- supplies
- tools
- labor
- operating overhead expenses
- costs of the facility used to manufacture the items
To clarify, visualize the process involved in manufacturing spaghetti sauce or manufacturing an automobile. These costs are paid for by cash, depending on payment terms.
Cost of services
The cost of services includes
- equipment
- supplies
- tools
- labor
- operating overhead expenses
- the facility.
For instance, think of the process involved in providing services in a medical office.
Operating expenses
Operating expenses include
- utilities
- rent
- telephone
- office equipment and supplies
- property tax
- legal expenses
- repair and maintenance
- insurance
- advertising
Operating expenses are paid by cash depending on payment terms.
Above all, owners and managers can use the budget to help decide which operating expenses can be adjusted if there is a change in operations.
Depreciation and amortization
Depreciation and amortization are expenses in the income statement. And these expenses do not use cash.
In short, capital assets are posted on the balance sheet and include buildings, machinery, equipment, vehicles used for business, and computers. The depreciation expense for these assets is the depreciable cost (cost less salvage value) over the estimated life of the asset.
Intangible assets lack physical substance and include patents, copyrights, and trademarks. Amortization expense reflects the decrease in the value of the intangible asset.
To sum up, these assets are paid for by cash, or if financed, paid over the term of the loan.
Capital assets
The capital asset budget includes the acquisition or disposition of long-term capital assets.
Capital assets, when acquired, are long term assets. Banks, finance companies, and equipment manufacturers normally provide financing for these assets.
Disposal of assets, when sold, increases cash.
The balance sheet in a financial budget
The budgeted balance sheet, similarly, has the same categories as the actual balance sheet.
Current assets
Similarly, typical categories of current assets include cash, accounts receivable, inventory, and prepaid insurance. Payment terms determine when the accounts are converted to cash.
- Revenue to customers, as a result, is typically recorded as an increase in accounts receivable.
- Inventory is purchased through accounts payable.
- Insurance companies request payments in advance for property and liability insurance. Prepaid insurance is increased when payments are made and decreased when the expense is recorded.
Long-term assets
Long-term assets include physical and intangible assets that a company plans to hold more than a year.
Physical and intangible assets are long term assets. Banks, finance companies, and equipment manufacturers normally provide financing for these assets.
Accumulated depreciation and accumulated amortization are accounts used to record depreciation expense and amortization, respectively.
Liabilities
The current liability section, however, includes accounts payable, the current portion of debt service, interest payable, and wages payable along with other current liabilities.
- Accounts payable increases with the liability for operating expenses and the cost of materials for inventory. The payment terms determine when payments are made.
- The payment for debt service is paid based on the agreement.
- Interest payable and wages payable are other current liabilities that increase when accrued.
However, the long-term liability section includes the long-term portion of debt service.
Shareholders’ equity
Consequently, the budget process includes the stockholders’ equity section.
Firstly, shareholders’ equity increases with net income from the company or an investment by the shareholders.
Likewise, shareholders’ equity typically decreases with a net loss of the company, dividend payments to shareholders, or stock repurchases.
Statement of cash flows in a financial budget
In addition, cash flow management involves having a good understanding of the company’s cash flow projections. The level of detail needed determines whether the budgeted projections are by week, by month, by quarter, or by year.
In addition, any shortages in cash flow will require a short-term alternate source through a line of credit. On the other hand, overages of cash flow provide opportunities for investment.
Review of the budget to actual variance reports
To sum up, owners and managers need to understand the importance of the budgeting process and take ownership of it. The variance reports provide information to help determine if changes need to be made.
Properly using the budget helps when opportunities arise or when business disruptions occur.
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