The purpose of a budget for a small business is to estimate the revenues and expenses for a given period of time. Usually budgets are created for at least a year in advance, divided up into monthly periods. Some ambitious business owners prepare 5 year budgets. In that case usually only the first 2 years are prepared with monthly details.
Before getting started, it is necessary to determine what basis of accounting you are going to use. It is most helpful to prepare the budget on the same basis of accounting that you use to prepare your monthly financial statements. Generally, you would choose between the cash basis of accounting and the accrual basis. The accrual basis gives you a more accurate financial reports because revenue is recorded not when you get paid, but when you earn it. Also, expenses are recorded not when you pay them but when you owe them.
You may argue that what you really want to know is if you have enough cash to run your business or if you will have to go looking for ways to finance it. That would be a good observation. So you would need to prepare a cash budget in addition to the budget that would compare to your financial statements.
But let’s start with the basics.The first thing to remember is to keep it simple. If you have previous financial statements, you can base the budget on the business’ history. But don’t be too quick to adopt the outcomes of the past. Budgeting is a planning activity and it is an opportunity to improve your business. It will help you see mistakes of the past and plan for improvements in the future. While budgets can be based upon historical data, they should not be so entrenched in the past that your business is no longer responsive to change.
If you do not have financial statements, that is no problem either. Budgets can be based upon your reasonable goals for the future of your business.
Generally the income statement is the target of the budgeting process. It is also true that if you expect to invest in fixed assets you should definitely understand the timing and extent of that investment as it relates to your available cash and borrowing.
So now we have identified 3 budgets that should be considered.
- Operational budget prepared on the accrual basis of accounting
- Cash budget so that you can determine the extent and timing of cash needs
- Budget for major purchases of fixed assets and other business investments.