Creating a budget can help a startup entrepreneur set goals and evaluate the viability of a business idea. It can also help established small-business owners gauge the financial health of their companies, identify new investment opportunities, and measure progress. In short, no business should be without a working budget.
Yet many small companies do operate without formal budgets, or they seldom consult the budgets they draw up, says Wendy Alexander, director of small business for Capital One Financial (COF). Alexander, who provides small-business advice for the Better Business Bureau, spoke recently to Smart Answers columnist Karen E. Klein about how to develop a business budget, what to include in it, and what pitfalls to avoid. Edited excerpts of their conversation follow:
Why does a would-be entrepreneur or a small-business owner need to devote the time to creating a working budget?
For a startup CEO, a well-planned budget is crucial to assess whether an idea is realistic, from a business and financial perspective. Once a company is in motion, it's a tool that tells you whether or not your financials are on track. If you experience unexpected windfalls or expenses, your budget acts as an early warning system to alert you to those things. And, of course, a budget is key to getting loans, bringing on new partners, and attracting investors.
With a budget, you'll have a history of performance that allows you to show what you planned to do with your company, and what you have achieved. Every entrepreneur on the inside of a company looking out knows her business and believes in it. But [someone on the outside looking in wants] to see planning and deliverables. Building a budget is step one in being able to do that.
Don't most companies have budgets?
Most, but not all. We've found that a substantial number of the micro-businesses we counsel do not have working budgets. The reality is, most small-business owners found their companies because they love whatever it is they are producing or providing as a service. Managing the finances is secondary to most of them. So, if they feel like the financial matters are more or less under control, they don't bother to create a formal budget.
Also, small-business owners are always strapped for time, and the last thing they want to spend a lot of time on are financial details. What's key is to make the commitment to do a budget, and then make it as simple -- but also as effective -- as possible.
How do you define a budget, and what elements should it include?
Very simply, it involves identifying the income that the company is bringing in, and also identifying the expenses that are going out. Every company should track its income, expenses, and profits, and project those numbers about a year out, or even a couple of years out. Doing that shows how the company is expected to do in the future, and as time passes, those expectations can be compared to how the company actually does. That comparison shows the entrepreneur, and perhaps investors, how the company is performing and whether or not goals are being met.
There are three primary financial statements that go with a budget. For a very small business, the cash-flow statement is the most important document, as most small companies work on a cash basis. I tell entrepreneurs that if they're only going to create one financial document, they should make sure they have a monthly statement of cash flow. After that, it's not terribly difficult to also produce regular income statements and balance sheets.
How do small-business owners make realistic projections about what their financial performance will be over time?
If they are already in business, they should have a lot of historical data they can look at and go from there. A new business owner will need to do some research.
Start by pulling together all your anticipated sources of income. Then think about whether the business is seasonal, what additional income sources might come along in the near future, and what your marketing plan is likely to generate in terms of increased income throughout the year. Next, you do the same thing for your fixed costs and variable expenses, thinking about each major line item and what it is expected to cost. Once you've pulled the pieces of the puzzle together, you need to plug in the numbers.
How do you come up with those?
You research prices and what things are likely to cost. If you can, you research the sales of other people in the same market you're in. Something to remember is that it always pays to be a little bit conservative with your numbers. It's always great to have some contingency funds. So, don't constrict your business from taking advantage of good opportunities, but do build a financial cushion into your budget.
What are the dangers of not having a budget?
The biggest danger is running blindly into a nasty surprise. Some of those surprises could even put your company out of business. For a startup company that doesn't establish a budget, it may find that even if it is selling as much product as expected, or has attracted as many customers as is realistic, the numbers just don't add up. It may simply be impossible to make a profit at the business, even if you achieve all the mental goals you established upfront. A lot of times with startups, entrepreneurs are focused so completely on recruiting customers that they don't realize how much their expenses are going to eat into their income.
What are some of the common mistakes you see in budgeting, and how can entrepreneurs avoid them?
The biggest mistake is for a business owner to treat a budget as a one-time exercise, or a once-a-year exercise, rather than as a living document that they're using to run the business day to day. Often we see entrepreneurs who have prepared budgets, but only because they are trying to get a loan, or they're doing their taxes. They put all this time and effort into drawing up the budget, then they set it aside and never consult it again.
Another mistake is making a budget unrealistic, not putting in the right amount of detail, or having some key elements in there, but getting bogged down when it comes to making projections. Don't worry too much about having them be absolutely accurate.
And the final most common mistake is that entrepreneurs usually need help with their budgets, but they don't ask for it. Having a CPA or other financial adviser help you prepare a first-time budget is a great idea. After that initial budget is drawn up, many entrepreneurs can do the updating themselves. Still, it helps to have a professional looking over your shoulder, especially at tax time.
Myriad software products are available for budgeting. How does a small-business owner choose the right one?
We tell our customers that the program they select should, above all, make them feel comfortable and be easy to use. If it's heavy on jargon and looks like it will take months to learn, avoid it. It also helps to have software that's specifically formulated for small-business owners, and sometimes it can be helpful to choose programs that are industry-specific. Usually, though, small-business owners don't need a lot of specialized budgeting tools. A general program works just fine and tends to be easier to use.