Budgets: The Financial Crystal Ball
It’s that time of year again. The kids are back to school. Baseball season is winding down, and football season is well underway. The days are getting shorter, and there’s a chill in the air. This can only mean that we are in the midst of what some people call their least favorite season. . .
For some companies, budget season begins much earlier in the year. For those fortunate few, the finishing touches are now nearly complete. For others, the process has not yet begun. Still others – for a variety of reasons – don’t even do a budget.
For purposes of our discussion, we’re going to use the terms budget, forecast and projection interchangeably – although in practice they have different meanings.
Approximately 80% of the businesses we work with do not use a budget at the time we begin working together. Nearly 100% of these businesses acknowledge that they should have a budget; that they’ve wanted a budget for quite some time, but they really don’t know how to go about it or don’t have anyone on staff who’s capable of putting it together. Or they don’t have the time.
There’s also a small percentage who think that budgets or projections are a waste of time because their business is “different”, usually because their revenue is difficult to predict.
How will you know?
If you don’t even attempt to look ahead and determine what is likely to happen next month, next quarter, next year. . . how will you know if it’s acceptable or unacceptable? How will you know if you’re facing a potential crisis because of lack of revenue. . . or a potential crisis because of lack of resources? If you don’t bother to look, how will you know what you should do to change direction?
Doug Hicks, a colleague and a recognized expert in ABC (Activity Based Costing) implementations often says “I’d rather be mostly right, that precisely wrong” when discussing projections. In other words, you don’t need to spend excessive time trying to get an exact, precise number because any number you settle on is going to be wrong. However, if you spend time getting the underlying assumptions reasonably correct, your projections should be in the ballpark. There is virtually no chance of predicting precisely what your revenue is going to be next month, let alone six months from now. But you probably have a good chance of predicting it within a certain range. From there you can do “what if” analysis and plan accordingly.
A good start – but not enough
We’ve all heard the expression “Cash is King”. Unfortunately, unless you use the cash method of accounting (as opposed to the accrual method) the P&L doesn’t tell you much about the company’s cash flow. The balance sheet and cash flow statements are needed.
Many business owners don’t have a good grasp of what the balance sheet or cash flow statements are telling them, so there may be reluctance to spend time creating projections for these statements that no one pays much attention to. But with a few minutes of training & explanation, the statements will become relevant and helpful.
Our guess is that less than 10% of small companies that actually do projections incorporate a balance sheet and cash flow statement. Why? Because it’s difficult. It requires assumptions, and it’s subjective. Not as scientific as a P&L. So it’s skipped.
Is Cash really King?
Going the extra mile and completing the projected Balance Sheet & Cash Flow Statement will help to answer important questions about cash flow, such as:
- Can we afford to buy this piece of equipment? Expand the Building? Launch this new product?
- Will we have enough cash for bonuses/tax payments/debt service?
- Should we request a larger line of credit?
- Will we have sufficient collateral, or be out of formula on our line of credit?
- Should we request progress payments from customers?
These are critical questions that should be tied in with the P&L projections to ensure all the numbers are linked together and that any changes in assumptions automatically roll through all the statements.
When a banker asks a business for financial projections, they are driving at one issue: Is the business going to generate sufficient cash to repay its debt? In order to answer this question, a projected Balance Sheet and Cash Flow Statement are necessary. If this information is important to the banker, it ought to be important to the business owner as well.
We have seen clients make dramatic improvements in their businesses simply by managing the business with an appropriate budgeting tool. When the data is in front of you, you have the ability to make critical decisions and impact the future. It’s tangible. Alternatively, when the projection data is bouncing around in your head, it’s competing with too many other things and is not organized for decision making. Similar to goal setting, the key is to write it down, and manage it.
Commit to using budgets & projections as a management tool in your business. . . and watch the forecast become reality.