What small business owner wouldn't want more money in their company? Think of the help you could hire, or the equipment you could buy to expand.
As entrepreneurs, whether you are a founder of a startup or a web3 company, or a professional that has started their own practice (say a veterinarian, dentist, chiropractor, optometrist or lawyer) you are naturally geared to growth and risks. But when was the last time you reviewed your spending? Have you ever set spending goals?
As a business owner, it's natural to overlook this area. There is so many other things going on, as long as cash flow is positive, spending almost doesn't matter.
But it does.
As we briefly discussed in our Definitive Guide To Managerial Accounting For Small Businesses, a lot of money can be lost over time if business expenses go unchecked. So why not take the time to review them, set a budget and make it part of your formal business processes?
A business budget is just like its personal counterpart. It is a financial plan for a your company, for a set period of time. A business budget estimates revenue and expenses, and at a very high level, will tell you how much money you have to spend as you build your business.
A business budget is most effective when it is created and reviewed regularly, usually on a monthly basis, so that business owners are consistently aware of where they sit relative to their plans.
The Difference Between A Budget And A Forecast
There is always a lot of confusion around the difference between a budget and a forecast, particularly a cash flow forecast, so it's good to note that here.
A forecast is a prediction of future revenue and expenses based on current and past trends. You can think of it as a best guess as to what's actually going to happen.
A budget, on the other hand, is a plan. Budgets are set in advance and are essentially targets. These targets can then be compared against actual results, allowing entrepreneurs to better manage their business.
Highlighting spending and helping save money is a key benefit of a budget, hence this article. But there are many other benefits, including:
Budgets are a key component of any business' financial process and we advocate for their use as much as we can.
Creating a business budget is similar to creating a budget for your personal finances. At an extremely basic level you need to:
Of course, this is an oversimplified framework. To create a realistic budget, a lot of thought and effort should go into your estimates, especially when it comes to spending.
Accounting software is extremely useful in this exercise. Because it houses all of your historical financial information, its data can be used to create good estimates of future income, expenses and expenditures:
Whether you leverage your accounting system or not, you should start the budgeting process by creating a future looking sales or revenue estimate. The easiest way to do this is to review your historical sales data and use that as a starting point. You can then adjust these numbers for any:
With income estimates done, you can then determine how you are going to be spending money in the future. Your business budget should get a lot more detailed with your spending because:
Before we dig into the different types of spending there can be, we want to point out the use of the term spending throughout this blog. We are careful to make that distinction as spending doesn't always take the form of an expense (technically speaking that is). You could spend money on a loan repayment, or spend money on buying an asset, and in both of these cases, they would not show up on the income statement as an expense.
We are therefore using the term spending because it is more all encompassing. And if your goal is to save money (the topic of this post), you want to look at all outgoing cash flows.
When you create a business budget, a key type of spending you will want to be aware of are your variable costs. Variable costs, or variable expenses, are any expenditure that changes in direct proportion to something else. They are often closely tied to sales, as the amount of product or service being produced changes. Some common examples of variable costs include:
When you are creating a forward looking business budget, ensure that variable expenses are estimated accurately. Because they can vary widely, they are a common source of budget errors.
When you create a business budget, you will also want to consider fixed costs. Fixed costs or fixed expenses are those that remain constant regardless of how much product or service is being produced. They are often related to the administration and overhead of running your business, and often include a large number of recurring expenses. Some common fixed costs include:
Most entrepreneurs have a good handle on their variable expenses and fixed costs. As part of the business budget planning process though, you also need to know when your business spending is mandatory. Mandatory costs are those that you are legally required to pay and often have a set payment schedule. They need to remain rigid in their amount and timing within the business budget because of that. Common mandatory costs include:
When you are reviewing your spending, it is also important to look at any unexpected business costs that came up in the past. It's good to thoroughly assess if these were truly one-time charges, or it there is a possibility that they might occur again in the future. Common unexpected expenses include:
If you have just started your business you might not have past history or knowledge on any of the costs listed above. Here you have to rely on more thorough estimates and ensure you are considering all of the initial expenses or costs that your business will incur. This might include typical items like:
But don't also forget:
Don't be afraid to reach out to people who might be able to help build out a fulsome list. Knowing what you are getting into in terms of spending as a startup, and planning around that, gives you a big advantage.
If you've read this article to this point you know how to build an accurate business budget. Now the question is: how do you actually use it to save money?
Remember that the purpose of a business budget isn't just to create a future looking profit and loss statement, it's to create targets that you can measure, work towards and try to hit. So it isn't enough to just create estimates. To save money with a budget you need to:
When building a small business budget, most people typically just go through the routine of making accurate, forward looking estimates. To truly make an impact though, business budgets should be aligned with your business goals and spending should become strategic. That means you should:
When you create a business budget you should review your business goals. What is your business model? How much revenue are you looking to make? What do you think your net margins should look like?
Now, does your business budget match these goals?
If it doesn't, it should. And if it does, how could you make it even better?
Aligning your small business budget to your strategic goals is a simple, but very powerful process.
What spending will help you reach your business goals? What spending will give you the most return on investment? Prioritize this spending in your business budget and ensure that you always have enough funds for it.
Review any spending that isn't a priority. If you were to cut costs in these areas would your sales or general operations suffer? If not, reduce what you spend in these areas to minimize expenses and cash going out the door.
Review the spending that remains in your business budget. Can any of it be adjusted? Consider if it can be, then set targets or limits for all of the estimated cash outflows.
Once you have aligned your your small business budget with your general business goals, and put some strategic thought into your spending and spending targets, you will have a great performance measure that you can use to compare to actual financial results. This comparison is called budget to actuals, or variance analysis, and can be used to adjust and optimize your business operations.
Comparing your budget to actual financial performance is pretty straight forward. You will want to compare each line in your budget to its related line item in your financial statements and ask the following questions:
After you have considered the questions above, you will want to put some thought into how you could change business processes to improve. To save money, you will specifically want to:
You will want to repeat this review process on a consistent and frequent basis. This will ensure that you are always on top of your spending, are highly aware of areas of overspending and are constantly thinking of ways to improve your spending patterns.
Carrying out this business budgeting process will save a lot of money over time:
And as we mentioned at the start of this post, what small business owner wouldn't want more money in their company... or in their own pocket?
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You might have heard these grim statistics before: more than 80% of all small businesses fail within 10 years, and more than 80% of those businesses fail due to cash flow issues. While some dispute the exact numbers, the underlying issue can't be. Cash flow is important. Period.
One would think that one of the most important business areas would be well understood. That isn't the case though. Cash flow is still one of the most ill-understood topics within the small business community. And forecasting cash flow? Even though it is just as important, it is even more misunderstood.
Jump to a section of this post:
In this post we will shine light on these misunderstandings, talking about what cash flow is, what cash flow forecasting is, the different types of cash flow forecasting there are, and how forecasting your cash flow can greatly benefit your small business whether you're a founder of a startup or a web3 company, or a professional that has ventured out on their own (say a veterinarian, dentist, chiropractor, optometrist or lawyer).
So, let's start with the basics: what is cash flow?
Cash flow is simply the movement of money in and out of your business. Money coming in is called inflow, while money going out is called outflow. Your business' cash flows can be positive (more cash inflows than outflows), negative (more cash outflows than inflows), or neutral (equal cash inflows and cash outflows).
The movement of money within, and through, any business is extremely important. At a basic level, every entrepreneur sets out to make money. So stripping everything down, each business' ability to generate positive cash flow, consistently over time, determines just how good that business is performing.
The more cash flow a business can make, the better it is doing.
Now, the above discussion on the importance of cash flow might seem overly simplified, and it is, but most small business owners don't have a great handle on this basic construct.
And there are two reasons for this:
Double entry accounting underpins all accounting as we know it. It requires that every financial transaction to be recorded in at least two different accounts. For example, when you make a sale, you would record this transaction both in your sales account on your income statement and your cash account on your balance sheet.
While this system provides greater accuracy and transparency around business finances, it also makes measuring cash flow more difficult. And that's because changes in cash can occur in two places: your income statement or your balance sheet.
There are two basic methods of accounting: cash accounting and accrual accounting.
Cash accounting only records transactions when the actual cash changes hands. So if you make a sale and the customer pays later, you wouldn't record that transaction until you collect payment from the customer.
Accrual accounting records income and expenses as they are earned or incurred, regardless of when any actual cash is received or paid out. Using our same example, if you make a sale and the customer pays later, accrual accounting would record the sale right away and create an accounts receivable. It would then eliminate that receivable and increase your cash balance when you collected payment.
Accrual accounting is a double edged sword. It creates financial statements that are more accurate and reliable for various users, but also creates timing differences, estimates and other complexities that aren't necessarily well understood by business owners.
The cash flow statement is the report that helps overcome the shortcomings that accrual accounting and double entry accounting processes make. This report ties the balance sheet and income statement together within your typical financial reporting. It measures all cash inflows, all cash outflows and eliminates any non-cash estimates that are also contained within your financials. And ultimately it reconciles all of this information to the cash balance contained within all of your bank accounts.
You can see two different forms of cash flow statements: those using the direct method and those using the indirect method.
Cash flow statements using the direct method are considered by some to be more accurate. This method reports all cash inflows and cash outflows from your business operations separately from any other inflows or outflows. This could include things like customer payments, vendor payments, interest income, dividends and other operational items.
The indirect method is a bit more simplified. It adjusts your net income for any timing differences between when you record accrual based items and when the actual cash is paid or received. This reconciles your net income to your actual cash. While this method isn't as detailed as the direct method, it's also not as susceptible to error.
Regardless of the method used, cash flow statements are a very important piece of your financial picture. As mentioned previously, they show how cash moves through your business. That said, cash flow statements are historical in nature. They show you what your business did, but not where your business is going. To see that kind of information, you will want to use a cash flow forecast.
A cash flow forecast is a projection of all of your future cash flows. It is a best guess, based on all available information, of what you expect to happen in the future. This includes things like expected:
A good cash flow forecast will show you:
This will give you a clear picture of where your business is heading, and how much cash you will have on hand at any point in time.
We touched on some of the high level benefits of cash flow forecasting in our Definitive Guide To Managerial Accounting For Small Businesses. Simply put, knowing the future net cash flow of your business, and your estimated cash balance at any point in time gives you a lot of power as a business owner. You will be able to:
By forecasting cash flow, you can see when your business might have a shortfall of cash. This allows you to take steps to avoid or mitigate the effects of a cash shortage, such as delaying expenditures, extending payments on accounts payable or shoring up working capital with short term debt.
Cash flow forecasting will give you a better understanding of how money moves within your business allowing you to more effectively manage your activities with operating cash. This can be particularly helpful if your business:
Knowing when and how you will get paid, and how and when you will make payments will make you a lot less reliant on debt and lines of credit.
A cash flow forecast will give you a better understanding of your business's financial health. This information can then be used to make better informed decisions about how to best use your resources.
Do you have enough cash to buy the equipment you need to grow and hit your sales targets? Can you afford to hire that stellar employee you interviewed? If you open a new location how will that impact your bank account in the short and long term?
Whether you have negative cash flow or a host of cash surpluses, thinking through exactly how you will progress your business, and knowing the effects of these decisions is an extremely helpful exercise. It will surely boost your confidence.
A cash flow forecast will help you track your progress towards your strategic business and financial goals. The information gleaned from the cash flow forecasting process itself can be used to adjust your budgets and your business plans, making these documents dynamic and more relevant as your operations change.
There are a number of different types of cash flow forecasts. Just like cash flow statements there are different methods you can use to create a cash flow forecast. And depending on your goals, the time frame you use in your cash flow projection should change.
Similar to its cash flow statement counterpart, a direct forecasting shows the exact cash inflows and outflows that result from your business' operations. This is the more straightforward approach to cash flow forecasting as it directly ties to all incoming cash receipts and outgoing cash payments.
Indirect forecasting does not start with your business' operational cash inflow and cash outflows. Rather, it begins with your company's net income figure. From there, non-cash items and changes in working capital are added back into or deducted from the bottom line to get to a net cash flow figure.
Indirect cash flow forecasting is more common associated with three way cash flow forecasting. This cash flow projection method forecasts your income statement, balance sheet and cash flow statement and ties them altogether. Hence the term three way forecasting.
Three way cash flow forecasting is sometimes viewed as the most robust way to cash flow forecast. It eliminates a lot of possibility for errors, especially when using a spreadsheet, and also presents bank ready financial statement projections that can be used for lending purposes. This method is typically a lot more customized however, can take a lot more time to create and maintain, and sometimes isn't as easily understood by entrepreneurs.
Long term cash flow projections are typically forecast from one year to five years out, with most going to three years in range. This type of cash flow forecast is most often associated with strategic planning and indirect/three way cash flow forecasts. These types of estimates are often used to:
A short term cash flow forecast is much more operational in nature. It can range from days to months in terms of time frame, and often does not go beyond a year. This type of forecast is much more granular in nature, and has much more accurate information in terms of timing. It is often updated quite frequently, as regular as weekly forecasts or daily, and is ultimately used to answer the question "do I have enough cash to do X?" in the near term.
The biggest difference between a short term and long term cash flow forecast is its use. Long term forecasts are more strategic, while short term forecasts are more operational.
The best analogy is a road trip using a map. A long term cash flow forecast determines exactly where you are going and loosely determines how you will get there. A short term cash flow forecast is used while you are driving to that destination, constantly shifting due to traffic, construction and road closures.
It is often a best practice to use both a long term strategic and a short term operational cash flow forecast.
An accurate cash flow forecast can be a game changer. Whether you're a professional, such as a veterinarian, dentist, chiropractor, optometrist or lawyer, or a founder of a startup or a web3 company, you will experience cash flow issues. Studies show that the vast majority of business owners have at least once in their lives.
Knowing exactly when that cash flow issue will come, and what you are able to do to mitigate the problem is a definite advantage. One that will let you sleep a whole lot better at night. And that's exactly why cash flow forecasting is a must-have tool.
Business budgets are powerful tools for small business owners if used properly. Learn how you can use them to spend less and save more in this article.
Knowing exactly where your business cash flow is headed will let you sleep a whole lot better at night. And that's exactly why cash flow forecasts are a must have tool for every small business.
As a business owner you are busy. This definitive guide will show how managerial accounting will get you back to your entrepreneurial dream: creating something you love, helping people in the process, and earning money and free time while doing so.