In order to identify new opportunities and ensure that they are operating on a profitable basis, small businesses need to incorporate a review process at the start of each financial year into their management process. The starting point in the process is to put together projections for what sales they might reasonably expect to make, and then factor in the resources, including funding, needed to deliver them.
Afterwards, they can use the resulting plan as a route map for what the business needs to do over the following twelve months, setting out the company’s overall strategy and allowing any decision making to refer back to the plan to ensure that the decisions align with the plan.
The plan will represent one possible way of achieving the business’s goals, but it will be based upon a series of assumptions, and in the real world, things often happen that take us either by surprise (these can be both good and bad). The plan should therefore be regarded as simply a benchmark against which to track progress, and should not be followed religiously if events change and challenges or opportunities not allowed for in the plan arise (i.e. if situations arise that make the assumptions on which the budget was prepared invalid).
In the finance world, plans such as the one described above are referred to as the annual budget. As circumstances change, the business should consider developing revised plans (often referred to as forecasts) that show an alternative view of where the business will end up at the end of the financial year. These forecasts will provide an updated map for the business, and should allow for changes that have manifested themselves after the budget was created.
Check out our most recent article in the forecasting series around why financial forecasting is vital for your small business.
Before developing your initial budget projections, it is important to fully understand what the key differences are between a budget and a forecast. The key difference between these seemingly identical exercises is that a budget lays out the initial outline for what a business wants to achieve in a given period and involves a greater element of considering the state of the markets in which the company operates, its’ longer term goals and the resources the company currently has at its’ disposal.
A forecast on the other hand provides a revised outlook for how a business might now perform based upon updated knowledge of the economic environment (usually in a much more summarised format, and pulled together in a shorter timescale).
In essence, a budget is a quantified expectation for what a business wants to achieve. Its characteristics are:
- The budget is a detailed representation of the future results, financial position, and cash flows that management wants the business to achieve during a certain period of time.
- This document will generally only be updated once a year and becomes a benchmark for that year.
- The budget is compared to actual results to determine variances from expected performance.
- Management takes remedial steps to bring actual results back into line with the budget.
- The budget to actual comparison can trigger changes in activity and commitment including performance-based compensation paid to employees (the aim here is to align the goals of the employees with those of the business owners).
Conversely, a forecast is an estimate of what will actually be achieved. Its characteristics are:
- The forecast is typically limited to major revenue and expense line items. There is usually no forecast for financial position, though cash flows may be forecasted.
- This document is updated at regular intervals, perhaps monthly or quarterly.
- The forecast may be used for short-term operational considerations, such as adjustments to staffing, inventory levels, and the production plan.
- Variance analysis tracking actual performance against the forecast will provide insight in to how well the business is performing against the latest estimates, with a view to highlighting areas where improvements can be made or opportunities that can be exploited. Large variances can indicate poor forecasting, which in itself can be a call for remedial action.
- Changes in the forecast do not impact performance-based compensation paid to employees.
The budget’s key strength is that as a more formal process, it allows managers to consider the direction of travel of the business, and if properly undertaken, highlights the resources (e.g. levels of staff, services required, funding and capital expenditure) the company will need to achieve the objectives set. A forecast is a more tactical exercise in that it forces managers to consider the current position of the business at a point in the budget year and to revise business activity in order to maximise profits or other objectives in the face of current market conditions.
In short, the budget allows a business to consider and prioritise what objectives it wishes to achieve in a given period (generally over one financial year) and to set out a possible route map that will get it there. A forecast amends the budget to reflect changes in the outlook and economic environment and to either take a different route to achieve the same end goal or to set a more achievable outcome given a more current view of the company’s circumstances. Both are useful and both add value if used properly.
The following example will hopefully highlight how the budgeting and forecasting processes interact. A training business begins its annual budgeting process a few months before the end of its’ financial year. The MD wants to grow the size of his business and to diversify in to other sectors of the economy as they believe the company is too dependent on the retail sector. In discussions with the consultants and sales team, it emerges that the business has received enquiries from companies in the financial services sector and with some re-purposing, a number of courses they currently run could be made relevant to these new potential clients.
To make this change, some consultants will need to move from delivering training to developing the new courses, but by utilising freelance trainers, the business should be able to honour its’ current commitments. To fund the development period, the MD recognises he will need to temporarily increase the company’s overdraft limit, but projections show that revenues from the new courses should begin to reduce this need by the third quarter. The company prepares a budget based upon this strategy and this is used to convince the company’s bankers to grant a temporary increase to the overdraft facility.
At the end of the first quarter, the company finds out that one of its major customers has been taken over, and the acquiring company has an in-house training team, and so sales to this business are likely to drop significantly. Conversely, the consultants working on the new training courses have made better than expected progress on developing the new material and sales of the new products are likely to commence several months ahead of when the budget had anticipated them to.
A forecast based upon these changes in circumstances shows that while losing the client will hurt the business, the earlier than anticipated arrival of new revenues will help mitigate the shortfall and in the longer term will more than replace them. A slight re-phasing (or the possible shift to leasing) of an anticipated capital expenditure project would mean the company could remain within its’ banking limits. The forecast meant the MD was confident that the company’s cash resources were adequate and that they were able to ensure staff understood what the new direction of the business was.
EFM can support your business with budgeting & forecasting
This comparison on budgets and forecasts for uncertain times will help as a guide. If you’re seeking practical, hands-on support, whatever the circumstances, know that you’re not alone – and that EFM are here to support you.
If you would like to find out more about how EFMs bespoke, part-time financial management & business advisory services can benefit your business, contact the EFM team.
Our EFM Experts can help you to construct & manage your financial forecast and business survival plan effectively.
Get in touch via firstname.lastname@example.org or call 01582 516300 to arrange your free 1 hour 1-2-1 consultation.