To effectively plan for your future, you need to understand the difference between a P&L budget and a forecast.
Creating a Financial Roadmap
A ‘Financial Roadmap’ will help improve profit and cash flow, by ensuring funds will be available to spend on developing new products and services, marketing, sales, operations, customer service and human resources. Critically, to grow a business you must have funds available at the right time.
The easiest way to develop a financial roadmap is to have a budget and a cash flow forecast. Here’s the difference between the two:
- A P&L Budget is a financial plan – what you are going to sell, what it is going to cost, and what overheads you are likely to incur. It also includes finance costs such as interest. The budget sets out how much profit or loss the business is planning to make, usually on a monthly basis.
- A Cash Flow Forecast is a plan of when cash will flow in and out of the business. It’s important to have both, because a budget may show that you’re going to make profit, but customers take time to pay and suppliers require payment, often before customers have paid you. Plotting this out in black and white, so that you can see where the ‘peaks and troughs’ are, allows you to plan how you’re going to manage them.
A P&L budget may be required by lenders, but do a budget for yourself. As a business owner, it provides you with a fantastic financial roadmap to help clarify what everyone needs to work towards.
People often say that they can’t do a budget because they don’t know how much they’ll make. This initial lack of confidence shouldn’t put you off developing a budget with best estimates.
The best way to start a budget is to work out your ‘break-even point’ and then build your budget to work towards that goal. Break-even point is when your expenses and revenue are equal. Obviously this isn’t what you’re in business for, but it is a good initial target to aim for. To work out your ‘break-even point’, begin with your overheads i.e., the fixed expenses you incur whether you sell anything or not, such as rent, staff wages, equipment leases etc.
You then need to know what your gross margin is on sales. Gross margin is the percentage you make on sales after direct costs of your product or service, such as cost of the actual product. For example, if you know that products or jobs cost you 40% (on average) of your sale price, that means you’ve got a 60% gross margin left to cover your fixed expenses. If your yearly fixed expenses are $600,000 you will need to sell $1,000,000 to breakeven.
Monthly Fixed Expenses = $50,000
Cost of Goods percentage = 40%
Gross margin = 60%
Formula = Monthly Fixed Expenses / Gross Profit Margin
= 50,000 divided by 60% = $83,333.33
$83,333.33 is the monthly breakeven sales figure in this example.
Once you know your ‘breakeven’ sales figure, you can use this as a basis for your budget. By entering monthly figures into Float and playing around with increasing and decreasing monthly sales, to see what would be the impact of changes.
You could also work it backwards to calculate what profit you desire and therefore what you need to sell to achieve the result. Or, if you can find ways to reduce your direct costs, how much impact that could have on your profit.
Cash Flow Forecast
The cash flow forecast is similar to the budget, but focuses on the cash, rather than the profit. The cash flow also includes items such as tax, loan repayments, and dividends, which aren’t included in the budget. By creating a forecast, you can see what your monthly bank balance will be and keep an eye on cash ‘peaks and troughs’.
Once you know the pattern of ‘peaks and troughs’ you can play around with the numbers to work out how to retain a positive bank balance. It will also show you when you need funds to cover shortfalls or when you have a cash surplus.
With constant transactions occurring in your business it can be hard to nail down an accurate opening balance. This is one challenge of maintaining a cash flow forecast. Having fixed an opening balance you then plot in monthly what income you expect to receive. This is based on when and how much customers pay, and what you expect to pay out.
Float dynamically updates your starting balance based on the transactions that have been logged in your accounting software. Float then uses what actually happened to automatically adjust your forecast to work out your future cash position.
To summarise, both budgeting and forecasting are vital for business success – helping you sleep easier at night. One helps you remain profitable; the other helps your business to have the right amount of cash on hand.
If you’d like more information on how to improve your budgeting and cash flow forecasting, download our eBook ‘9 Smart Strategies To Set Your Financial Roadmap’.
CFO On Call are Virtual CFOs who can help set up your Budget and Cashflow right at the beginning. This ensures you’re making decisions based on accurate information and avoiding losses and ‘cash squeeze’.
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