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How to Develop a Budget for Your Small Business

Budgets are short-term plans for how businesses will operate, how money will be spent, and how income and revenue will be received.  A good budget enables a company not only to plan, but also to react to unforeseen circumstances.

There are a number of different types of budgets; the most common are cash budgets and capital budgets. Here is a close look at both.

Cash Budget

A cash budget is similar to a household budget.  The main value of a cash budget is that it can indicate periods when "cash in" and "cash out" are out of balance.  A cash budget is like a view of the future; it might protect your company from seasonal swings in cash flow, give you a sense of what expenses will be like under different business scenarios, and allow you to make decisions about hiring, expansion, and evaluate operations on a macro and micro level.

Cash budgets tend to be set up for at least one year, but you could choose to develop a cash budget for any time period that makes sense for your needs.

Cash budgets have three main categories. Two are easy to determine; the third requires a little work

  • Time period − what time frame the budget covers
  • Estimated cash position − how much cash you wish to keep on hand at all times.  How much cash you want to keep on hand depends on the type of business you run, the predictability of your cash flow (especially accounts receivable), and how often you feel opportunities may arise to make rapid investments or purchases of supplies, inventory, etc.
  • Estimated sales and expenses − in simple terms, cash in and cash out

The first two categories are, as mentioned, relatively easy to determine. The third, estimated sales and expenses, requires a closer look, since those items make up the bulk of a cash budget.  Estimating income (sales) is the foundation of a cash budget; once you have that number, many expenses naturally follow. The problem is estimating sales requires some amount of guesswork, especially if you are starting a business and have no prior history to draw upon. If that's the case, your best bet is to create a series of cash budgets: one using a sales estimate you feel is most accurate, and then other budgets at different thresholds, like 10% less than your best estimate, 20% less, 10% more than your best estimate, 20% more, etc.

Here is what a cash budget might look like (in simple terms):

Time Period: January 1 through December 31

Cash On Hand:

$20,000

Estimated Income

 

Sales of products

$200,000

Sales of services

$55,000

Other Income

$2,000

Total Income

$257,000

Estimated Expenses

 

Wages, salaries:

$120,000

Supplies

$20,000

Rent

$20,000

Advertising

$10,000

Inventory

$40,000

Equipment

$15,000

Total Expenses

$235,000

Profit/Loss

$22,000

Keep in mind the above is a high-level view of what a budget might look like. Each line item could contain a number of sub-categories for more detailed budgeting.  Cash budgets can and should change over time, especially as you develop a history of actual sales and expenses. The more historical data you have on hand the more accurately you can predict future events.

Capital Budgets

A capital budget is a tool used to plan major, long-term, cash-intensive projects like building new facilities, purchasing major equipment, or funding long-term research. Unlike cash budgets, capital budgets are light on estimates and heavy on financial analysis. Most businesses use one of several financial tools − Internal Rate of Return (IRR), payback period, and Net Present Value (NPV) analysis − to determine if a capital expenditure makes solid financial sense.

Here is a closer look at each tool; keep in mind the goal of this description is not to teach you the formula, but to provide an overview of each approach.

Internal Rate of Return (IRR): IRR is used to predict the potential of a capital investment based on future cash flow. The theory behind IRR is that capital projects will create negative cash flow in the beginning (when money is spent to fund the project) and later should create positive cash flows (as the project results in additional sales or income). The higher the IRR, the better the project is estimated to perform. Since IRR is expressed as a percentage, it is easy to evaluate one project against another to determine which generates the greater return.

Payback Period: The payback period is the length of time required for an investment to pay for itself, discounting the effect of interest or the time value of money to keep things simple. For example, a $4,000 investment that returns $1,000 per year has a four year payback period. Shorter payback periods are better than longer payback periods. For more information on payback periods, see the article Break-Even Analysis.

Net Present Value (NPV): Net Present Value evaluates the future dollars a project will generate using the current value of those funds. In other words, dollars received in the future are worth less than dollars received today. NPV takes into account the time value of money. NPV calculations estimate the amount and timing of project cash flows, then discounts future cash flows to determine a present value.

A key factor in NPV calculations is the hurdle rate. The hurdle rate is the minimum acceptable return on an investment. Different companies use different hurdle rates, taking into account risk, availability of capital, sales projections, etc. In effect, the hurdle rate is like an internal threshold helping to determine if a project makes sense.

Investors Bank offers a variety of products and services for Small Businesses throughout New Jersey and New York.  Please contact your local branch for information.

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