As a business grows and becomes more complex, the need for a successful budgeting and forecasting process becomes critical. Often, this task gets pushed to the side as growth becomes a bigger priority for small businesses.
Small business owners find themselves juggling many roles and wearing many hats, and as a result, even simple P&L budgets get overlooked.
There are five keys to successfully budgeting and forecasting that make it effective and worthwhile regardless of the size of your organization.
Why is Budgeting and Forecasting Important?
One of budgeting’s most redeeming qualities is it forces the organization’s leadership to establish tangible goals for the fiscal year. This is inherently good—it gives direction to the business and aligns all of the staff from the top to the bottom.
Forecasting gives the company goals and a benchmark to follow, and forecasting allows management to understand if the company is on the right track or not.
Budgeting
The budget process uses these goals to create a roadmap to reach the goals of the business.
Among the numerous benefits of creating a budget, perhaps one of the biggest and most beneficial is examining cost drivers.
Understanding how costs rise with revenue and where the marginal benefit of adding resources arises is critical for smart business planning.
While there are many ways to approach budgeting, the resulting financial plan provides a basis for measuring the organization’s success. Without it, arbitrary and ambiguous goals are difficult to monitor and gauge.
How to Build a Budget
Here are five fundamental steps to follow when you create a budget:
1. Review and Gather Inputs
First, identify all the inputs to your budget. This means knowing your fixed and variable expenses, your revenue streams, and anything else that will influence your financial planning. That way, you know what kind of data and information you need.
2. Analyze Historical Data
Review past budgets and other historical financial data. This research will give you a sense of past trends to help you set realistic revenue and expense goals for every fiscal month and year.
Look for spending patterns, seasonal sales, or other trends impacting your projections.
3. Engage Cross-Functional Stakeholders
Consult with key stakeholders in other departments. Talking to sales leaders, budget owners, and C-suite execs gives you a sense of how everyone views the company’s priorities and helps you build a budget that reflects the needs of the whole organization.
Consultation also makes your co-workers feel like they’re part of the process, which will help them buy into the budget.
4. Plan for Capital Expenditures
Identify any significant capital outlays needed during the budgeted period, such as equipment, plant, and property investments.
Include these in your budget to manage your cash flow and ensure your business has the necessary resources to operate and grow.
5. Prepare Financial Statements and Set KPIs
Then, take your budgeted numbers and create your basic financial statements: the balance sheet, the income statement, and the cash flow statement.
- The balance sheet shows the amount of cash on hand and the balances of your other business accounts, such as accounts receivable, accounts payable, and inventory.
- The income statement tells you your net profit or loss for the period.
- The cash flow statement simply tells you the movement of money into and out of your cash flow and other bank accounts.
Learn about the differences between the balance and income sheets here.
You will also want to identify your key financial performance indicators and other performance ratios that will track the effectiveness of your budget. Compare your performance against the prior period and the market.
Review and Explore Strategic Opportunities
Once your budget is set, look for opportunities to grow the business. This might include considering investment and divestment opportunities, assessing the business’s financial ability to take on more debt and equity, or finding ways to grow.
Consider strategic growth opportunities to help your organization take advantage of new opportunities in the market.
Forecasting
On the other side of the aisle is forecasting, which takes the budget and converts it into a projection of the future.
Forecasts are often used to measure future success if the budget is adhered to entirely. However, many other types of forecasting add substantial value to any business’s operations.
Cash forecasting is perhaps the most common form of forecasting and is crucial when preparing for the coming fiscal year. Maximizing cash flow is extremely important, especially in low-margin industries.
How to Create a Forecast
To generate your financial forecast, follow these steps.
1. Define Your Focus Areas
First, identify the key metrics the forecast needs to cover.
For example:
- Revenue growth
- Operating costs
- Cash flow
2. Update with the Latest Financial Data
Start with your latest financial data as a baseline, taken from business operations.
By incorporating real-time data, your forecast will truly reflect the state of your business at that specific time for more accurate predictions.
3. Establish a Forecasting Period
Decide on the timeframe you will cover in your forecast. Choose a monthly, quarterly, or annual timeframe, but be consistent in tracking performance and making comparisons over time.
For dynamic environments, consider rolling forecasts of more than one fiscal year to make your plan more agile and adaptive.
4. Identify Patterns and Trends
Examine past performance data and look for trends likely to continue. Are there consistent patterns in sales, expenses, and other critical metrics that can guide your projections? Notice when things change and how.
5. Adjust for Influencing Factors
Consider any changes that might occur, either known or unknown, that could impact your forecasts.
This includes:
- Product launches
- Economic shifts
- Regulatory changes
The more you can anticipate, the more you can account for in your forecasts, both internally and externally.
Using Budgets and Forecasts Together
Finally, the two work in tandem to produce a comprehensive guide to the upcoming fiscal year.
The budget guides expense and income management. On the other hand, the forecasts provide a means to measure the organization’s success in implementing the budget.
This marriage provides a plan that maximizes enterprise value.
The Keys To Budgeting and Forecasting Successfully
Understanding the importance of budgeting and forecasting is important, but what is more important is understanding how to implement the process successfully. These budgeting and forecasting tips will help you do just that.
There are five keys to budgeting and forecasting that, if followed, will yield significant benefits to any organization.
1. Make Sure The Budget Is Realistic
This might seem obvious, but it’s easy to get ambitious when preparing a budget for the first time. Thoroughly reviewing historical performance and identifying cost drivers takes time. Avoiding goals that are not grounded in reality is absolutely critical.
For example, it might be unreasonable to assume cost could be cut by 50% or revenue can grow by 60%. Approach the budget with a reasonable expectation of what can be accomplished with the resources at hand.
Growing a business is not an overnight matter.
Those who take a realistic approach to fiscal planning can expect to be rewarded with compounding results. However, a budget supports many goals besides growth.
For example, a budget might prioritize relieving debt or paying down lines of credit rather than prioritizing revenue growth.
Making a budget starts with realistic, measurable, and quantifiable goals. In this way, the budget becomes a tool for meaningful success, and the forecast becomes a meaningful gauge of performance.
2. Perform Scenario Planning
One thing budgeting and forecasting attempt to do is provide a roadmap for the fiscal year ahead.
However, unforeseen problems often interrupt the regular business cycle—COVID-19 was a great example. When preparing budgets and forecasts, consider multiple potentialities and run scenario analyses.
One rule of thumb is to always prepare a base-case budget and forecast, a scenario in which everything happens according to plan. Then, create a set of budgets and forecasts based on best-case and worst-case scenarios.
Approaching budgeting in this way provides a way to plan effectively against various scenarios.
3. Start With Clean Data
One of the major mishaps that can happen when preparing a budget and forecast is using bad data. As the saying goes, “bad data in, bad data out.”
It is especially important to start with a period that has been well reconciled and locked. Creating a P&L budget with outstanding P&L items or inaccurate payables/receivables can have serious negative consequences.
Always use clean data for your budget.
Because the forecast relies on the budget, this concept becomes paramount. If a forecast is created based on an inaccurate or incomplete budget, then it is essentially charting a course for disaster.
A forecast is essentially a financial model that attempts to execute predictive budgeting given the budget’s inputs. If the inputs are bad, the forecast is bad.
4. Create Short-Term and Long-Term Plans Using Tools, Budgets, and Forecasts
Budgeting and forecasting yield the greatest benefits when used in tandem to plan for both short-term and long-range outcomes.
That is to say, a budget should be created for the near term, less than 12 months, and a budget should be created looking forward several years. It is common to see two-, three–, and even five-year pro forma financials based on long-range planning.
Due to the sensitivity of maintaining sufficient cash balances, most businesses forecast cash out monthly and, in some cases, weekly.
These short-term cash forecasts are part of a larger years-long forecast. Similarly, budgets are created and reviewed quarterly and, in some cases, monthly.
Short- and long-term plans are important because they highlight problems as they arise and allow for quick responses to ensure issues do not get out of control.
In the same vein, they also ensure the business is making progress towards its defined milestones, whether that be expansion, acquisitions, or even divestitures.
5. Regularly Monitor the Budget and Update Forecasts
Once a budget is drafted, don’t let it simply collect dust on a desk. This is a meaningful road map to achieving the business’s goals.
The only way to be sure the organization is moving in the direction it should is to regularly monitor its progress against the budget and larger forecast.
It is a best practice to include regular milestones in your budget and forecast that, once achieved, make it obvious that the business is following the plan.
Achieving these milestones indicates that the organization is aligned with management’s goals and can also be used to gauge staff performance.
Certain instances might arise where unexpected events interrupt the organization’s progress on a budget and disrupt the initial forecast.
COVID-19 was a great example of a market interruption for which few businesses were adequately prepared. Because of this, businesses must prioritize regularly convening on the budget and forecast to make adjustments when necessary.
Using Budgeting and Forecasting Software
Because budgets and forecasts are critical to a business’s well-being, many organizations are turning to software that allows for more flexible and responsive financial management.
A good financial software package is easy to use and implement, allows for responsive changes, and provides helpful reporting.
Many organizations rely solely on Microsoft Excel due to its familiarity and cost, but this can be an oversight as fragmented workbooks and manual inputs can lead to errors.
These errors have larger implications. Every organization should be prudent and perform regular due diligence on software offerings that will add value.
To explore what Datarails budgeting and forecasting software can do for your business, book a demo today.
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