Definition of Budgeting for Business
Budgeting for a business is the process of preparing detailed financial statements that cover a given time period in the future. A company sets business targets for results it expects to achieve over the course of the next financial year. It then documents them in a format that allows the company to compare how it expected to perform financially against its actual financial results throughout the year.
Budgeting Time Periods
Budgeting can be prepared for short, mid-range, or longer-term time periods. Common time periods for budgeting might be a month, a quarter, and a year. The budget should develop sets of reasonable and attainable goals for the firm, using data and assumptions based on historical results, management insight, and knowledge of upcoming internal and external events or influences. For example, a sales budget tells employees what their sales targets are, and by when they're expected to achieve them.
Budgeting and Financial Forecasting
Budgets are often a company's first step in financial forecasting. Company budgets reflect the company's financial targets and goals. A financial forecast, while based on the budget, projects the reality view, or what the company actually thinks will happen.
The forecasted results get compared each month, quarter, and year against a company's actual performance, while the budget continues to highlight where the company wants to go in the future.
It is important to develop forward-looking views of the three main financial statements; the balance sheet, cash flow statement, and income statement.
Some may prepare a budget to go out five years, but the quality of budgets suffer because of the amount of unpredictability over a five-year period.
Most business owners start out with budgets that project income and expenses to establish the company's income statement. But other types of budgeting are also necessary for a company. For example, you also need to project the level of assets and liabilities you expect to have in the future, as shown on a firm's balance sheet.
Regarding the statement of cash flows, it is particularly important to include this in budgeting. Projecting cash flows is very important to ensure that the company is always in a positive cash flow position and can meet its short-term debt obligations. If you can develop good financial budgets, you can have more control over your cash flow, which is vitally important to your business firm so it can pay its bills in a timely manner.
Types of Budgeting in a Business Firm
Companies often have a "master" budget that captures the financial targets for its entire operation. In addition, a firm may develop more detailed budgets at a secondary level. Depending on its needs and complexities, a firm will formulate the additional, detailed budgets it needs to fine-tune the targeted revenue and expense for more complex areas of the business.
The three most important types of budgeting that many business firms focus on include capital budgeting, operating budgeting, and cash flow budgeting.
Other budget areas exist but these three establish a detailed foundation.
Capital budget. Capital budgeting creates a plan for the large expenses in a business firm. Capital budgeting illustrates the fixed assets that the firm predicts it needs to invest in, such as new buildings or expensive equipment. It is the process of budgeting or estimating the costs to obtain, expand, and replace fixed assets.
Having an accurate budget for large, expensive assets with multi\year lives like buildings, equipment, tools, and similar assets is important because of the large monetary investment and the life of these types of assets. If you make a mistake in capital budgeting, it could haunt you for a long time.
Operating budget. The operating budget, formatted as an income statement, is built up starting with the firm's sales forecast.
The budget of sales revenue minus cost of goods and selling, general, and administrative expenses essentially ends up at net profit. In the operating budget, determine what you need in sales revenue and the expenses the company will incur to support that level of sales while also achieving your profit goal.
Cash flow budget. The cash flow budget shows expected cash inflows (receipts or sources) and cash outflows (expenses or uses). The cash flow budget shows whether the company will have enough cash to continue meeting its monthly expenses over the budgeted time period. If not, the cash flow budget can reveal when to borrow and how much, if you don't have enough money to meet expenses.