The Budgeting Financials
Your budget becomes a set of pro forma financial statements. Pro formas are what-if statements, filled with budgeted, planned, and forecasted items. Unless you have a crystal ball, your budget is always a collection of educated best guesses about the future.
To keep things simple, a budget uses three basic financial statements: the balance sheet, the income statement, and the statement of cash flow. Another aspect is an explanation of your source of funds.
Source of funds
Your budget determines whether you have enough funds to run your business. Hopefully, you get all the money you need from selling products or services, but that’s not always the case.
The financial plan (also loosely called the business plan) explains the source of funds to run the business. You can raise money by borrowing cash (debt) or by offering investors ownership in the business (equity) in exchange for cash.
If you borrow, you repay a creditor the original amount borrowed (principal) and interest on the loan, usually on a written schedule. The interest cost and principal repayment must be included in the budget.
You can also raise funds by selling ownership in your business, offering investors equity. Equity investors are rewarded in two ways: stock appreciation and dividends.
The most common way to sell ownership is to sell common stock. Investors expect you to explain (through your budget) how you plan to generate a profit for the year. If the company is profitable, the value of their ownership in your business increases. They could eventually sell their ownership interest to someone else for a profit.
You also need to consider whether to pay dividends. Dividends are a share of the profits earned by the company paid to equity investors. Of course, without any company earnings, you can’t pay dividends.
Using the balance sheet
The balance sheet lists the company’s assets, liabilities, and equity (essentially the difference between assets and liabilities) as of a certain date. Think of the actual balance sheet as a snapshot in time; think of the budgeted balance sheet as a pretty good estimate of the actual financial statement.
Liabilities are claims on your assets. A liability means that you owe someone money. Liabilities include items such as unpaid utility bills and payroll costs you haven’t yet paid. Future interest and principal payments on a loan are also liabilities. When you pay a liability, you use an asset (cash, in most cases) to make payments.
This gets you to the balance sheet equation:
Assets – Liabilities = Equity
Consider this scenario: Assume you own a little shop. You sell all your assets — your inventory, furniture, and your building. You use the cash you receive to pay off all your liabilities — utility bills, payroll, and bank loan. Whatever cash remains after you pay off your liabilities is your equity. Equity is the true value of your business.
So now you can see the logic behind the balance sheet formula: Assets less liabilities equals equity.
Working with the income statement
The income statement shows revenue, expenses, and net income (profit) or loss. For most business owners, the income statement is the most important report. It shows whether a business was profitable over a period of time (such as a month, quarter, or year), whereas the balance sheet shows assets, liabilities, and equity as of a specific date.
The nice thing about modern accounting software is that it can generate an income statement almost instantly. Think of the budgeted income statement as a pretty good projection of your company’s sales, expenses, and profit.
The income statement formula is incredibly simple:
Revenue – Expenses = Net income or loss
Analyzing the statement of cash flows
The statement of cash flows analyzes sources of cash (cash inflows) and uses of cash (cash outflows) over a period of time. Cash flows are grouped into three categories: operating, financing, and investing activities. When an accountant puts together a cash flow statement, she reviews every transaction that affected cash.
A very simple model is what’s in your checkbook. If inflows are good, you probably have enough cash to operate. If the checkbook shows that you’re overdrawn, outflows have exceeded inflows, and you’ve got trouble.
The goal is to assign every cash transaction to one of three categories, although most of your cash activity is in the operating activities section. To simplify the process, find the financing and investing activities first — because they represent fewer transactions. The remaining transactions are operating activities.
The three cash flow categories are:
Operating activities occur when you run your business each day. You buy material, pay for labor, ship goods, pay interest on loans, and collect cash from customers.
Financing activities occur when you raise money for your business, and when you pay lenders or investors. You receive cash when you sell equity, and you receive cash when you borrow. You pay cash when you pay dividends, and you pay cash when you pay down a loan (pay back some of the principal).
Investing activities occur when you buy or sell assets. Writing a check for a new vehicle and receiving cash when you sell equipment are investing activities.
The statement of cash flows lists the beginning cash balance; all the cash activity for the period, grouped into three categories; and the ending cash balance:
Ending cash balance = Beginning cash balance +/– Net cash flow of operating activities +/– Net cash flow of financing activities +/– Net cash flow of investing activities
A simpler formula is
Ending cash balance = Beginning cash balance + Cash inflows for the period – Cash outflows for the period
The ending cash balance in the statement of cash flows equals the cash balance in the balance sheet (well, it’s supposed to, anyway). For example, if the statement of cash flows is for March, the ending cash balance should equal the balance sheet cash balance for the last day of March.
When you create your budget, it should include all three financial statements (balance sheet, income statement, and statement of cash flows).