Many of us switch off when it comes to talking business finances and planning for each new year. We find it overwhelming when we are busy, creatively constricting, or we just plain don’t understand how to do it. Today here on the Valued blog we want to help you understand how to set a budget, why to set one and of course how to use it as a strategic tool for your business growth.
What is a business budget?
A business budget simply put is a financial plan for the next twelve months. It covers how and where you will spend money and accounts for your predicted and desired income, based on your goals as a business and your personal goals for the business.
If however, you are looking for a bank loan, other business funding, or even angel investment you may be asked for a budget that covers as many as three or even five years. Typically a twelve-month budget is much more realistic for forecasting terms in day to day business and this is something we love to help our clients with here at Valued.
Why do you need to create a business budget each year?
Whilst there will be instances where things change during your trading year, your business goals ideally remain the same (broadly speaking). If you missed our recent article on setting goals that make a difference to your business planning, then we recommend you go take a look. There we cover exactly how to set goals that you can keep track of and succeed with.
A budget is a big part of that process because it outlines your desired annual income, broken down into your product and service offerings. This clarity gives you targets that you can set across the company, helping you to track your progress at designated points throughout the year.
It also helps you keep track of your expenditure, which is crucial. You may find that you can immediately cut costs, or renegotiate prices and payment terms of contracts with suppliers that help improve your profit margin and cash flow enough for investment in growth, or staff wage increases, or maybe even that family holiday you have been dreaming about.
Speaking of profit, our budget shows us when our weakest months are in terms of cash flow. If we don’t have the cash to pay our staff or buy in materials, then we quickly run into issues as a business. Having a budget and a forecast helps us make decisions on things like pricing and the regularity of client charges. If we can go back to our customers and shorten payment terms, or raise our prices to a more reasonable position, then that will cover those slower months and increase our money pot for investment where we need it.
A business budget is a very powerful decision-making tool. The insights we gain from completing the budget initially and the targets and tasks we then set ourselves gives us a much better chance of succeeding.
Download your business budget spreadsheet
There are plenty of budget software tools out there and if you use Xero we suggest Fathom as an integration because this tool gives you budgeting software and cash flow, so you can compare the two as you are planning (which we will cover why later on). If however, you’d like to get started with a simple system to understand how powerful this financial tool is, then please download our free budget spreadsheet.
How clarity in your business finances allows you to have open discussions
Many of our clients, when they first come to us as business accountants, ask us in our end of year meetings, “How am I doing compared to last year?” This is the first time they have seen or accounted for their sales, expenses and profits in twelve months. Introducing a budget planning session into their management workflows changes everything.
Here’s an example of why. Let’s call this fictional client Barry. Barry owns a sash window installation business in South London. He has a small team of just four, including himself. Each member of staff is responsible for creating job estimates for clients, after an initial meeting, then following that up to win the business. During each job, the staff member is also responsible for ordering supplies, managing job costs, and invoicing the client.
Barry is behind on unpaid invoices. Barry’s competition is hot on his heels trying to win his prospective business at every turn. Demand is increasing and his small team can’t cope.
What Barry really needs is a part-time bookkeeper, possibly another installer and some help with marketing in this lucrative area of London. But Barry can never find the cash.
If Barry was convinced to start creating and using a business budget, then he would be able to have important team discussions on targets, project management, costings and even invoice charging. Shoring up some of these areas would help Barry find the money for that bookkeeper to chase unpaid invoices, which in turn would give the business a more fluid cash flow and opportunity to invest in further key staff, or freelancers.
How rigid should a business budget be?
As we are all too aware things don’t always go according to plan. Covid is a great example of that and something every business owner in the nation had to consider. For those of you with a budget in place, planning when these rare and sometimes major inconveniences come along is a much easier thing to do - you simply go back to your budget and start making adjustments.
Need to work from home? Check your budget to see where you have the funds for extra, or new equipment. Want to open a brick and mortar shop for your online business this year? Check your budget and see where you have the funds for rent, insurance and refurbishments.
Your budget is a living, breathing tool, that you review every single month. This gives you twelve chances to succeed this coming year, over the one chance you’ll have if you wait for your accountant’s end of year review.
Don’t forget seasonality in your financial planning
Seasonal trends in demands for your goods and services will be something you have noticed over your years of trading. Make sure that you account for these sensibly in your budget and use your cash flow to make sure you have what you need in cash to pay staff wages and other bills during your lowest sales periods.
This allows you to create targets that stretch, but don’t break your sales team.
So what is the difference between a budget and a cash flow?
A budget is a forecasting tool for what you hope to do with your profit and loss. A cash flow is a report that details exactly what is happening with your cash at the moment (real-time if you like).
Let us give you an example. Let’s say that today you raise £10,000 worth of invoices. This is as per your budget projection for this month. The same day you also spend £3,000 on costs, leaving you a profit of £7,000, again all projected for in your budget this month. You could arguably say you hit your target for the month. Fabulous!
What happens if you give your clients 30 days credit?
This is where your cash flow comes in as an important tool to use alongside your budget. Your cash flow will show that you have £0 coming in this month (because those invoices probably won’t be paid until next month), but you still have those £3,000 expenses, leaving you in a position of -£3,000 loss, not profit for the month. Now if you do not have an overdraft, or cash in your account to cover those £3,000 of costs, then you are in trouble. This is where some business owners get into debt, buying into loans and credit cards at unaffordable rates, because they are not in a position to negotiate for that much-needed cash injection that they didn’t see coming.
Let’s fast forward to next month. Say you have £0 sales, but your invoices all get paid. This would give you £7,000 in profit on your cash flow and budget. This balancing allows you in month two to use that profit where you need it, making it much clever whether you can afford those extra pair of hands you need.
Of course, this is a very simplistic example, imagine the complexities in your own business.
A cash flow would also account for VAT and assets, whether that’s a new company car, desks, or computers. Maybe even machinery. This is not accounted for in your profit and loss budget. Using the two simultaneously in your monthly business financial meetings is crucial to achieving your goals.
Why can’t I just add a 5% increase to my annual budget every year?
We are always trained to forecast a 5% increase in sales, costs and profit each year, but what does this achieve? In truth nothing. You are still where you are last year. Never truly progressing.
If you can create a budget alongside your cash flow, you can work backwards with your goals. Let’s say you’d like to take your family to Disney this year and it’ll cost you £12,000. Then you know your business has to produce £12,000 net profit this coming year. You could break this down into a target of £1,000 a month, or maybe four months of £3,000 extra profit in your key trading period.
From this, you can work out what your gross profit needs to be based on last years overheads and your thoughts on cost-cutting exercises. Then going up the ladder again you can renegotiate with suppliers and relook at client invoicing terms and even raise your prices to help grow your profits.
Working backwards it is much easier to see where your gaps and opportunities are, meaning that an increase of £12,000 in profit is much more achievable.
A goal quickly becomes a reality like this.
Your next steps
- Start with your why as a business owner - what do you really want from 2022?
- Layout your budget mimicking your last year of trading. Don’t forget to download our template!
- Follow our 7 tips for business growth this year and work your financial goals into your budget from the bottom up, remembering to include seasonality and any forecast cash flow issues.
- Create targets based on how you will achieve your new monthly budgeted profits. Make sure you discuss this with your team.
- Monitor your budget and cash flow each month to review your budget in line with any unexpected dips or increases beyond those that were forecast.
- Watch your goals become a much closer reality and enjoy the fruits of your hard work.