Chapter 3 of the Business finance basics section in the 'Achieving financial success' series

Chapter 3 of the Business finance basics section in the 'Achieving financial success' series
Chapter 3: The importance of budgeting

By Jackie Russell-Green*

Budgeting is the tool that develops the strategic plans of the business into a financial statement setting out forecasted income, expenses and investments for a given period.

Budgets enable you to evaluate and monitor the effectiveness of these strategic plans as they are implemented and to adapt the plan where necessary.

Most small businesses operate without large cash reserves to draw on; therefore, budgeting will provide the financial information required to assess if your strategic plans will support ongoing operations.

In short, budgeting is the process of planning your finances over a period.

Budgeting can also provide an opportunity to plan for several years ahead in an effort to identify changing conditions that may impact on business operations and cause unexpected financial difficulty.

Good-practice budgeting requires the following:

• preparation of strategic goals

• budgeted timelines that align with the preparation of financial statements

• regular comparison of budgets against actual financial results as disclosed in the financial statements

• scope for amending activities and targets where actual results indicate that budgeted outcomes will not be met.

In short, budgets are one of the most important financial statements, as they provide information on the future financial performance of the business.

If planned and managed well, your budget will be the central financial statement that allows you to monitor the financial impact of the implementation of your strategic plans.

Profit and loss budget

A profit and loss budget is an important tool for all businesses because where activities can generate profit, your business will be less reliant on external funding.

The budget is a summary of expected income and expenses set against the strategic plans for the budget period. This is usually one year, although in some cases the period can be shorter or longer, depending on what you are going to use the budget for.

Although your accountant can be of assistance in the preparation of this budget, it is important that you understand how it has been developed and know how to monitor the outcomes against the prepared budget to ensure your business will achieve the required financial outcomes.

HINT
By preparing a profit and loss budget annually, you will be in a position to determine if your business plans will support the ongoing activities of your business.

Preparing a profit and loss budget

The key to successful preparation of a profit and loss budget is to undertake the process in an orderly manner, involving all key staff and ensuring the goals of the business are clearly understood prior to the preparation.

There are two methods of preparing a profit and loss budget:

incremental - where the previous year’s activities are used as the basis for preparation

zero-based - where all the financials are prepared without consideration of past activities

For annual budgeting, the preferred method is incremental, as zero-based requires an enormous amount of dedicated resources and time to prepare.

In the case of project- or activity-based budgets, zero-based may be more suitable, particularly for new projects for which there is no previous financial data.

An annual budget preparation policy should be documented and followed. It could include some or all of the following steps:

1. Review the approved strategic plan and note all required activities for the budget period.

2. Separate activities into existing and new for the new budget period.

3. Identify and document all assumptions that have been made for the budget period.

4. Review prior year’s profit and loss statements by regular periods (usually monthly or quarterly).

5. Prepare the profit and loss budget for the selected period using all the steps listed above.

TIP
An independent profit and loss budget can be developed for separate projects to assess the financial viability of each project.

A budget is the future financial plan of the business. It is where the strategic plans are translated into financial numbers to ensure the plans are financially viable.

Assumptions

To ensure your budget will be a useful tool, you need to spend some time planning what you think is going to happen in your business in the future.

As you are preparing your estimates on income and expenditure, you will be estimating how your business will operate in the future, and these are referred to as assumptions.

When determining your assumptions, it is best to use realistic targets that you believe will be achievable.

Using your historic financial information and looking for any trends in this information is a good place to start.

Also, any industry information provided by independent, reputable companies will give your assumptions credibility. This is particularly useful if you are going to submit your budget to a potential or current lender or investor.

HINT
All assumptions made during the planning process of preparing budgets should be realistic and documented.

Make sure you write down all the assumptions and then establish a financial number that reflects the event. Once you have completed the table of assumptions, attach it to the budget.

This way, you will remember what you anticipated happening and, when reviewing your budget against the actual figures, this will help to determine why the actual results may not be the same as your budgeted numbers.

When listing your assumptions, if you believe there is some risk the event may not occur, include this detail, together with any actions you could take if a particular assumption turns out to be incorrect. In this way you will already have an action plan in place.

Let’s return to Joe’s Motorbike Tyres and see how he is going to set his budget for Year 2 of his business.

Using his first-year profit and loss statement, Joe is now going to set some assumptions for the second year of his business.

We can see Joe is now confident that in the second year he can increase his sales by 50 per cent. Of course, with increased sales comes an increase in expenditure to support these sales.

He has developed a plan of what the Year 2 profit and loss statement will look like.

Joe will need to monitor his actual results, checking them against this budget, to ensure his plan will be achieved.

TIP
When documenting your assumptions, include both the risk assessment of each assumption and the anticipated action required to match the risk. That way, if actual events do not match your assumptions, you will be well prepared and have an action plan already in place.

Monitoring and managing your profit and loss budget

There are a number of ways that the profit and loss budget can be managed.

As noted in Chapter 1, it is important that regular preparations of financial statements - in particular the profit and loss statement - are prepared so that the actual activities can be compared with the budget.

Standard practice is to prepare monthly statements; however, for smaller businesses, quarterly preparation and comparison may be suitable.

Where the profit and loss statement is prepared on a monthly basis, the budget will need to be separated into months for the budget period.

At the end of each month, the actual results are compared with the budgeted results and any variances analysed.

Such variances should be noted on the reports and explanations provided.

Each variance should be categorised as either a timing or a permanent variance.

HINT
Remember, the more regular the reports, the quicker operations can be reviewed for financial impact so action can be implemented immediately where required.

In a timing variance, the estimated result did not occur but is still expected to happen at some point in the future.

In a permanent variance, the expected event is not likely to occur at all.

The power of this analysis is that each variance is documented for future reference, and, where required, action can be taken to counteract future variances or implement new or improved activities to ensure the strategic goals that underlie the budget can still be achieved.

TIP
Regular review of budget against actual results will provide information on whether your business is on track to achieve the plans formulated when you first prepared your budget.

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The full Guide is available in the .pdf attachment, or here »

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Jackie Russell-Green is the National Technical Manager of Staples Rodway who assisted in the development of this guide for CPA Australia New Zealand Division . You can contact them directly here »

You can read the Introduction to this series here »  The related Glossary is an important resource. And readers are encouraged to read this page first »

Chapter 1 is about Understanding financial statements and you can read it here »

Chapter 2 is about Assessing your busines's financial health and you can read it here »

Chapter 4 is about Maintaining Profitability and will follow next week.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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