Creating a business budget for 2020 will not only benefit your business in the next year, it will help establish a roadmap for success well into the future. A year ago I explained why your business would benefit from having a budget. This year, I'll get into the details of how to create one.
The primary benefit of having a budget is that it sets parameters. It forces you to make reasonable assumptions about how much your business is liable to spend in the coming year. That, in turn, helps you figure out how much income you'll need to cover your immediate expenses and also plan for long-term investments in the business.
While a budget is never exact, it's not just a wild guess, either. A budget's main value is to create an accountability tool. By setting a budget, you create a gauge for determining whether a particular initiative is working or whether you should change course before sinking more time, money or other resources into a losing proposition. A budget can also help identify successes that you should double down on.
Learn From the Past
The simplest way to create a budget for the coming year is to review past performance. If you've worked off a budget previously, compare that budget against the actuals. Look at areas that were over or under, and try to determine why.
Even if you've never used a budget per se, you can still review your numbers to set a realistic budget for the coming year. Which expenses exceeded your expectations, and why? Which revenue generators fell short of your projections? Are your records detailed enough for you to assess what worked and what didn't? If not, you need to rectify that.
Maybe the problem is that your records contain too much detail. If that's the case, you could benefit by simplifying your budget for 2020.
Focus on Your Cash Flow Budget
This is the big one. Your budget should incorporate big buckets of cash flow from operating activities as well as cash flow from financing activities. And it's critical that you monitor this portion of the budget throughout the year. If your cash flow falls significantly short for any reason, you need to respond immediately. Bankers will have more confidence in you as a business leader if you talk to them early rather than when you're desperate.
If you wait until the last minute to get financing, you can end up with operational disruptions that keep you from paying people on time. That can do lasting damage even if you do weather the storm. Also, you'll probably wind up with less-favorable terms from the lender, including tougher covenants and higher interest rates. You can avoid that by demonstrating you're a worthwhile credit risk. Providing a plan that includes detailed budget information is a solid first step.
Allow for Irregular Cash Flow
Some types of businesses have irregular cash flow. Seasonal businesses, for example, receive incoming cash primarily during one period of the year, but may incur their largest expenses during another time of year. How do you handle regular fixed cash outlays when your incoming cash flow is irregular or when you don't know what your incoming cash will be at all?
Again, the idea isn't to be exact; it's to examine your past numbers and set a budget that you can use as a yardstick. Armed with that information, you should look for a lender who will allow you to set up a line of credit that you can draw on in the worst-case scenario. (Setting a budget also helps you determine what that worst-case scenario looks like.) Having a contingency plan with a reputable lender will keep you from resorting to credit cards or term lenders who charge astronomical (over 20%) interest rates.
Bear in mind that revenue doesn't always equal cash flow, either. In some businesses you get paid in advance, while in others you get paid in arrears. If you haven't provided the services to earn incoming cash yet, you shouldn't be counting that incoming cash as revenue. (There's a reason "Don't count your chickens before they hatch" became a cliché.)
Following an accrual model will help you more accurately determine if your business is profitable over time and allow you to see if your margins are high enough. If they aren't, you need to either cut costs, increase prices or do some combination of both. Your revenue cycle and your cash cycle should be cleanly accounted for. Setting a budget helps you accomplish this, and accomplishing this helps you set your next budget. The cycle becomes self-perpetuating.
Be Sure to Budget for Yourself, Too
A common question among business owners is, "How much should I pay myself?"
Your tax professional can give you the best answer. That's because there's an optimal income from a tax perspective based on specific rules regarding how your business is set up (LLC, S corporation, etc.). Long story short: If you have plenty of cash in the bank, you should default to minimizing your business and personal income taxes.
But you shouldn't make that decision in a vacuum. You need to look at the big picture and consider various hypotheticals. How economically sensitive is your business? If there's a recession, will your business just slow its growth, or will it face a severe cash crunch? If you lose your biggest customer tomorrow, how much trouble will you be in? How flexible are your costs? These are all important considerations when you look at how much income you should be drawing from your business.
The rule of thumb is that you want enough cash on hand to finance three to six months of business operations, just as you would with your personal finances. You can meet that cash reserve through a combination of actual savings or lines of credit.
Re-evaluate Your Budget Regularly
It's important to remember that an annual budget is a great starting point, but that's all it is — a starting point. It's vital that you revisit your budget regularly to see if you need to make any adjustments. At the very least, you should review your financial results vs. your budget every quarter, but monthly reviews are even better. If you missed (or exceeded) your goals last month, that should determine how you manage your business this month. That's what an annual budget is for.
And While You're at It, Budget Beyond Next Year
As you build your budget for 2020, you should also map out your strategic plan for the next three to five years. Think about both the external and internal factors that could shape the direction of your business:
- External factors: What information is available regarding market conditions for the next several years? What's the likelihood of your expenses increasing due to factors that are beyond your control, such as price spikes or material shortages? How can you handle increased cost without losing profit?
- Internal factors: How quickly is your business growing? Will you need to add employees or move to a larger facility? Talk to your lender about what your plans are and what their criteria are for giving you money for major investments. A budget will let you map out these milestones in greater detail.
As the saying goes, even the longest journey begins with a single step. A budget helps ensure it will be in the right direction.