Preparing a Budget

When you prepare a budget or forecast, ensure that the income statement, balance sheet and cash flow forecast interact, so that last minute changes in any one of them will flow through to the other document. Any person that receives the budget will be much more impressed if the document has all four essential parts to it:

• Earnings statement forecast
• Balance Sheet forecast
• Cash flow forecast
• Assumptions used

Most budgeting software has the capacity to do this and it is relatively easy to do in Excel with intermediate level Excel skills.

Of course, it is essential that the budget as a whole tie together and be logical. If one makes some basic assumptions and builds them into the model, as one builds the budget, it is possible to have results that are believable (as long as the assumptions are credible). Examples are:

• Receivables on the balance sheet must be proportionate to sales. This can be achieved by using formulas which include an assumption of the days sales outstanding and the budgeted sales in the month (and previous months);
• Inventory on the balance sheet must be relative to cost of sales. This can be achieved by using formulas which include an assumption of the days of cost of sales maintained in inventory and the budgeted cost of sales in the month (and previous months). In a seasonal business there may be different days sales used as one builds inventory, compared to months where you are drawing on the inventory to satisfy peak sales requirements. For additional sophistication you could have separate formulas for raw materials and finished goods in a manufacturing business;
• Accounts payable can also often be modeled based on cost of sales with an additional factor for those expenses that are not included in cost of sales;
• Fixed assets are a function of the planned acquisitions, which should be laid out in detail in the assumptions, and the amortization policy.

A cash flow statement is usually required by bankers and other financial backers and is easiest to model in a similar format to the one that appears in the annual financial statements (unless you do not include a cash flow statement in your annual financial statements) and fortunately this is the same format that they require. As this is primarily a function in the changes in the balance sheet lines, it is very easy to model and will satisfy most needs. Of course that means that it is only as accurate as the balance sheet forecast. Do not be fooled into believing that this is only for the bankers – this is a very effective warning tool if there are possible cash crunches in the business and also can highlight errors in the balance sheet forecast.

A good budget consists of all four of the parts mentioned above and is modeled so that the links ensure that changes in one area automatically result in changes to the other affected areas. This makes last minute changes less likely to result in errors and also gives the reader confidence that real life will be close to your forecast.

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