How to Prepare an Annual Budget for a Small Business
One of the easiest ways to prepare a budget is to use a budget planner app. Younger people are more likely to use these new budgeting tools because the modern way to deal with this is to use an app. Budgeting apps are easy-to-use, and their interactive nature via a smartphone makes the information instantly accessible when any purchasing decision is being made. A budgeting app is like a fitness device that checks your financial health while the activity is occurring.
How To Prepare an Annual Budget For a Small Business
Even when we realize that only about one-third of people use budgeting tools for personal expenses, it is shocking that nearly the same amount of small business owners operate without a budget. According to a survey by Clutch, a US research and ratings company, half of small businesses did not create a formal budget in 2020
Fortune reports that almost 100,000 small businesses in America closed permanently due to the pandemic. For the approximately 30.6 million other small businesses, which are still operating according to the Small Business Administration, it is critical that they create an annual budget to avoid being another business that closes permanently.
Now that we convinced you to pay attention to your small business's budget, here are the steps to take to prepare an annual budget.
Collect Past Financial Information
If you are the type of business owner who throws receipts in a box and hands a big pile to your accountant at the end of the year for tax filings, you will not manage your small business properly. Collecting information for tax purposes is the bare minimum required by law; however, it does not provide you with enough information to manage the ongoing business efforts.
If you are not good at bookkeeping, hire someone to help you organize the accounting and get your past financial information in a useful order, so you can see the big picture of how your small business is operating.
The rule of thumb in business is to work with three years of past financial information. However, this requires an adjustment now because the pandemic caused a major financial disruption. This disruption was not negative for all small businesses.
Some small businesses did better during the pandemic. These businesses were well-positioned to benefit from the increased interest in their products or services caused by the pandemic. Many small businesses did worse due to the pandemic and, if they survived, may not fully recover for quite some time. The point is that using the data from 2020 is not going to be helpful and reliable for budget preparation without making some adjustments due to the effect caused by the pandemic.
Pandemic Factor
Unless your business is a startup in 2021 or 2022, you need to develop a “pandemic factor,” which is a multiplier (up or down) that can be applied to the 2020 data to normalize it. You probably want the figures to be more in alignment with the averages from the pre-pandemic years. For example, if the business was up 20% overall, then a decision needs to be made about this new level. Is it sustainable? Does the future expectation include a retrenchment back towards average pre-pandemic levels? If the business went down due to the pandemic, is that the trend that will continue, or is there an expectation for a rebound?
The first part of preparing a budget is to determine the pandemic factor about how it affects your business going forward. Whatever the expectation is for the pandemic effect, this pandemic factor should be applied to future estimations of your budget requirements.
Organize the Information By Categories
To manage budgets more easily, break things down into categories of revenue and expense groups. A good rule of thumb to follow is to use separate categories for any revenue or expense amounts representing more than 5% of the total.
On the revenue side, pay close attention to any concentration of revenues coming from a few sources. Fragility exists in some businesses that rely heavily on just a few sources to create most of their revenues. Loss of these revenue sources can suddenly put the business into a financial catastrophe. If this is the circumstance for your business, if possible, make an effort to seek a more diverse revenue profile that does not depend heavily on only a few sources.
As part of the expense-organization process, break the expenses into two main categories of fixed expenses and variable expenses. Fixed expenses do not change regardless of the revenues. Variable expenses increase in alignment with an increase in revenues resulting from increased business activity.
Manage Debt
Having a good credit history with a high credit score helps you potentially get better credit rates. Manage credit and use online debt tools to make sure you use credit wisely and get the best deals.
Evaluate Working Capital
A business's strength is the amount of working capital that a small business has to utilize in operations. Calculate working capital by determining the difference between the business's current assets (cash, accounts receivable, and inventory) and the current liabilities.
One of the main factors that cause a business to go bankrupt is under capitalization. One common problem is starting a business without enough investment money and credit capacity to sustain operations. Other problems include not collecting account receivables efficiently and carrying significant amounts of bad debt. Another problem is paying excessive interest on borrowings. Small businesses may get into trouble by having too high of a credit balance as current liabilities.
If you have insufficient working capital, consider selling off non-performing assets, raising investment funds for the business, and re-structuring credit lines.
Cash Flow
If working capital is the strength, then the cash flow is the lifeblood of the business. Things that increase cashflow are faster inventory turnover. Inventory turnover is how fast the cash used to produce or buy inventory turns back into cash after the inventory is sold and paid for by a customer. Small business owners need to have adequate cash flow to pay employees and buy materials as needed. Even a business that is operating profitably can run out of cash.
Factoring receivables to improve cash flow is a method of borrowing against their value for a short-term loan. Businesses may sometimes run out of cash when waiting for payment for a large order or if business activity is lower because the business is seasonal. If you find yourself short of funds, work with a cash management tool.
To manage cash flow, take these steps:
- Create a cash flow statement (of the current position) and monthly cash flow projections
- Compare actual monthly cashflow with forecasted cash flow
- Monitor receivables and manage payment terms
- Exercise caution when giving credit to customers or offering extended payment terms
- Offer discounts for early payment of your invoice and use late charges to discourage delinquent payments. Promptly send any bad debt to collections
Estimate Revenues
After you take all the steps outlined above to manage debt, cash flow, and working capital, the next thing to do for budgeting is to estimate revenues for the next twelve months to make an annual budget.
Be sure to consider any normal variation in sales that occurs as part of the business activities. Adjust for the effect of the pandemic accordingly. Do not overestimate revenue projections by being overly optimistic. If revenues are more than expected, there is little harm done by that; however, the business may face a significant financial challenge if revenues fall short.
Always give serious consideration to improving revenues with careful attention to the gross margins in sales. The 80/20 rule says that it is common for a business to receive 80% of its revenues from only 20% of its customers. Focus on building revenues from valued customers and on those things that you can sell with high margins that increase profitability.
Estimate Fixed Costs
Fixed costs are things you must pay that are a certain amount. Examples of fixed costs include rent payments, leasing expenses, insurance premiums, and annual membership dues. Fixed costs are sometimes called overhead. Fixed costs include the salaries for employees, employment taxes, and the cost of their benefits. Workers who are paid hourly and can receive overtime pay are not fixed costs. That hourly-paid portion of the labor force comes under the category of variable costs.
Estimate Variable Costs
Variable costs include hourly wages, material costs for manufacturers, supplies, and other variable costs included in the cost of goods sold. Examples of variable costs include sales commissions, shipping costs, and usage-based utility services, such as gas or electricity. When profits are higher than projected, you can allocate more to variable costs to help your business grow faster. If profits are lower than expected, you may need to cut back on variable costs to maintain profits.
Value engineering is a type of analysis that considers all the variable costs to uncover inefficiencies. For example, there may be things to consolidate or eliminate to reduce costs in the manufacturing process. Cost-effective materials purchasing, packaging re-design, and improvements in shipping logistics are other ways to reduce costs.
Make the Best Budget Using the Best Tools. Welcome to the Budgetry Store.
Allow For One-Time Expenditures And Emergencies
One-time expenditures include things like capital investment in the purchase of land, building renovations, or equipment. You must plan for these major expenses carefully.
Emergencies are inevitable, and most businesses are ill-prepared for them. Do you remember the Dot Bomb? This was the stock market correction that happened in 2000 when the bubble burst on dot com companies' inflated valuations that lacked sufficient revenue. The Dot Bomb bubble burst put many unprepared companies out of business, including some very substantial ones like eToys, Webvan (food delivery), and Pets.com. At one point, Webvan had a market valuation of $1.2 billion with 4,500 employees and then, less than two years later, went into liquidation.
Amazon survived the Dot Bomb, not because it was profitable but because it raised billions in cash reserves. The founder of Amazon, Jeff Bezos, convinced investors to give him billions before the Dot Bomb occurred. This capitalization allowed Amazon to continue. Amazon operated for six years without making a profit. For a long time, it was not certain that Amazon would make it. Fast-forward to today’s time, and due to the pandemic, Amazon revitalized the Webvan company and also operates another home-delivery service, Amazon Fresh, which made the Amazon company a small fortune in 2020 when everyone was stuck at home.
Bill Gates had a similar attitude about emergencies regarding his company Microsoft. He always maintained a full-year’s worth of his employees’ salaries in his emergency reserve from near the company's inception. He never grew the company so fast that he could not maintain this reserve. His very reasonable logic was that if things went badly, he would have a full year to figure out how to get his business back on track. That is exactly what he had to do when the Internet commercialized. When this happened, he said that he had to re-invent the Microsoft Company from the ground up, which he did.
Companies that failed during the pandemic might have benefited greatly if they have the foresight to follow Bill Gates's strategy. If you do not include setting aside an emergency reserve as part of your annual budgeting, you are very likely making a serious mistake that could expose your company to the risk of failure. Business interruption insurance can help, and having a year’s worth of employee salaries held back in a bank account can really help too.
Budget Preparations
After you have estimated the revenue and expenses for the upcoming year, made allowances for one-time expenditures and emergencies, you can prepare a monthly budget based on your projections. These budget projections are called pro forma estimates. They are your best guess of what will happen over the next twelve months. The more detailed your evaluations of the business constraints and opportunities are, the more likely your pro forma estimates will reflect an accurate reality for the business.
Your annudal budget will have the format of:
- Revenues listed by category
- Expenses separated into fixed and variable groups and listed by line items
- One-Time Expenses
- Emergency Reserve
- Gross Profit (revenues minus all expenses and the reserve)
Break-Even Analysis
Every business benefits from conducting ongoing break-even analysis. This is done on the macro-level for the entire business and the micro-level for every product or service offered by the business. Small business owners, who understand and know the break-even amounts, manage their businesses more effectively.
The break-even is when the fixed costs are covered for the entire business, or the allocation of fixed costs is covered for a particular product. Any revenues thereafter only need to pay the variable costs, and the rest is gross profits.
There are classic examples of where break-even analysis is applied. One is “Black Monday,” which is a day of sales and also is associated with a calendar day that traditional retailers have covered all the fixed costs for the entire year. The accounting for the payment of all fixed costs is complete for the year. This means the retailer covered all fixed costs and is operating “in the black,” which means the retailer is profitable for the year.
Since every sale of a product after hitting break-even does not have to contribute to paying any fixed costs, the prices for a product may be deeply discounted. A product may be sold for a price that is just above the variable cost, and still, the retailer will make a profit.
Another example of a company that uses break-even analysis on both the macro-level of store-wide sales and the micro-level of individual products is how the pricing is done at Walmart.
Walmart allocates a portion of each sale to contribute toward the fixed costs up to a certain amount for a selected period, which could be a year, month, or week. When an individual product’s sales surpass the required fixed-cost contribution for a certain period, Walmart uses “Roll-Back” pricing to discount that product's price for the remainder of the period.
Smart shoppers at Walmart will wait to see roll-back pricing offered and then stock up on those things at the discounted price. Business owners who wish to maximize revenues can follow a similar strategy to the Walmart pricing plan.
Use Month-by-Month Comparisons as an Ongoing Guide
I like to use the analogy of sports and apply it to small business efforts. Think of your business as your favorite sports team that you want to do well. Staying on budgeting is a way to keep score. Operational efficiencies help create exceptionalism that makes your small business a champion. If you can think about business in this way, using a sports metaphor, it becomes easier to do the budget and track your success in following your annual budget plan. Sports without keeping score is less interesting. Your budget is your way of keeping score.
Accountants recommend that you pay close attention to figures that stray by more than 5% from your budget plan. This is an indication of a major problem that needs addressing.
Conclusion
Remember that budgeting does not have to be a laborious process. If you use online budgeting tools, then it is straightforward. Set aside some-time each month to go over the budget for the upcoming month and compare the expenses and income from the past month with the amount you estimated as part of your annual budget to see how well you are doing. Being proactive in this way is extremely satisfying. You will quickly see that this is a powerful way to help your small business thrive.