Don't get the "Budget Blues"

Fighting the Budget Battle is one of the Final Plan's bigger challenges.  Here are some weapons to help you emerge victorious. 

The most frequent problem is the Capital Budget's Sources and Uses of Funds don't balance.  The total of each has to be identical, otherwise your budget won't behave. 

Next on the list is understanding the difference between (1) your capital budget's initial inventories and (2) your operating budget's periodic replenishment of those inventories.  Doesn't that sound exciting?

I'll bet you can't wait to read more.

First, organize your Capital Budget's "Uses of Funds."  Account for all the money necessary for starting the business.  Think about all the equipment, staff wages and benefits, supplies and other "stuff" you'll need in order to be ready for your grand opening. 

Also, don't forget all the indirect costs of incorporating, obtaining business licenses, setting up your accounting system, insurance and much, much more.

There are three special types of startup costs you won't want to overlook.

1. The first is what we call "Working Capital."  This is the amount of cash needed to cover operating losses until the business is consistently producing positive cash flows (also known as the "Breakeven Point").  Fortunately, the spreadsheet automatically computes your Working Capital needs for you.  You just need to make sure it is making logical sense. 
2. Next are "Owner Distributions.  This item answers the question, "How will the Owners pay their personal expenses until the business becomes profitable?"  It is also sometimes called "Draws."  Calculating it starts with estimating the monthly amount the Owners need for defraying their personal living expenses.  Next, estimate the number of months until the business consistently generates cash flows the Owners could use for their compensation.  The product of these two numbers will then be the amount to include in your Capital Budget's Uses of Funds for "Owner Distributions."
3. Last, but not least, is a Contingency.  No matter good you get at budgeting, there always will be expenses you didn't anticipate or that will be more (and sometimes less) than you expected.  To cover these occurrences, include a lump-sum amount equal to at least 10% of all your startup costs; for especially uncertain ventures, I'd suggest bumping it up to 15%.

Second, prepare your Operating Budget.  Forecast the revenues your business is likely to generate and the expenses it must incur to produce those revenues.  In your plan's text, describe the assumptions and calculations that underlie these forecasts.  For the time being, don't worry about income taxes or any accounting adjustments; focus only on cash flows.

Prepare the Operating Budget for a three-year period by quarters (don't use months, that's too much detail).  Begin with your firm's startup stage, move through its launch and growth stage and show, in the third year, how it stabilizes at maturity.

Third, identify the Sources for the funds needed by your Capital Budget's Uses.  This will also be your firm's "Capital Structure."  Chances are you'll be using one or more of three sources:  (a) an equity investment by the firm's founders, (b) a bank loan or (c) a third-party investor equity investment.

Finding the right "mix" of these sources isn't "rocket science."  Study the amount of cash produced by the firm's operations in its third year; these represent funds that could be used for debt repayment and might then be the amount able to be borrowed as part of the initial Capital Structure. 

As a general rule, try to fund your firm's capital budget with founder investments or bank loans; third-party equity investments are extremely expensive and usually not worth the amount of control that must be given up.

Fourth, put the finishing touches on your budget.  Pay back your bank loan and check whether your assumptions still hold.  Were your contingencies enough?  Evaluate the amount of cash on hand versus the founder's initial equity investment; what was the rate of return earned by the business?  Express that rate on an annual basis and compare it with other investments you could have made.  How did you do?

TROUBLESHOOTING

If your budget isn't behaving, raise the hood and check these things. 

First, are your sources and uses of capital funds equal?  If they aren't, your budget will never make sense.  Add or subtract sources or uses until the amounts balance and see if that makes your budget better behaved.

Another problem area is Inventories.  They appear in two places and are treated differently in each.  First, you might have an initial inventory that is in the Uses part of your Capital Budget.  Make sure this is a "Positive" number.

Next, there's another "Inventories" in the Operating Budget.  These are "replenishments" and must be a "Negative" number.  When your business is operating, it is drawing down your initial inventory to make the products that are being sold.  As some point, you must replace the inventory that's been used.  To do so, you need to buy more materials for your inventories by paying out cash from your operating budget which explains why it is a negative number.

Finally, a word of caution about tinkering too much with the spread-sheet's formulas.  Be careful about plugging any numbers or overriding any formulas.  The cells are linked together in ways that will produce unexpected results if you fool around with it too much.  Be patient and try a little trial-and-error if all else fails.

Now that wasn't so bad, was it?