Failing to create and properly maintain budgets is a recipe for disaster, and it’s a story that has been played out for decades, both in personal and business finance.
Ultimately, everyone needs a budget and, more importantly, everyone should be in the habit of reviewing their budget routinely so that they can stay on track. But what are the 3 types of budgets you can use to get on track and stay there?
Your operating budget is basically the sum of your pre-tax income. Your operating budget will show you what type of financing you may qualify for and if there are ways you can minimize your tax burden to improve your cash flow budget.
If you want to calculate your operating budget, you just need to put together a profit and loss forecast.
What is a Profit and Loss (P&L) Forecast?
A profit and loss (P&L) forecast shows you the total amount of money you have brought in for a giving period on the very top line of the report. To follow, there is a summary of all the expenses you have, be it rent, cost of goods, etc.
You deduct these expenses from the revenue line and this results in your net operating income. If your net operating income is greatly reduced compared to your total revenue, this indicates that the majority of your budget is going towards expenses, so you may be keeping the lights on, but you’re doing little else.
On the other hand, if you deduct your expenses from your revenue and you have a high net operating income relative to your total revenue, you are going to have a lot of money on hand to re-invest into your business. That’s what you should strive for.
Increasing Your Operating Budget
One thing you need to pay close attention to when you sit down and look at your operating budget is the total % of your revenue that’s being deducted for various expenses. You then need to break those expenses down, line by line, and figure out ways to reduce them.
After all, one of the easiest ways to boost your net income is to reduce your expenses, so that should be your top priority. Examples of expenses that are often negotiable or easily reduced include insurance, which may just take a phone call to get a reduced rate.
You should go through and review your expenses in this fashion periodically--at least quarterly--because they will grow and change overtime as your business grows and changes.
Of course once you've got your expenses inline, the next area to look at is making more revenue. This could be through working a second job from home, affiliate marketing (like John Crestani), getting a higher paying job or asking for a raise. Regardless of the way you make more revenue, provided your expenses don't increase, every dollar of additional revenue will flow straight to your net bottom line and substantially increase your profit.
Making The Most Of Your Operating Budget
Remember that your operating budget is all revenue minus expenses before you pay taxes. This pre-tax income is the amount you’ll give to lenders when they’re determining how to qualify you for loans and other sources of capital.
However, when it comes down to actually running your business, you need to know how much money you have leftover after paying taxes. Otherwise, you could overspend and end up in a tough situation at the end of the fiscal year when your taxes come do.
After all, you’re going to have to pay taxes on all money your business generates (i.e., your revenue, which is the top line of your P&L statement) minus some qualifying business expenses. Ideally, you’ll calculate your estimated tax burden and factor this into your operating budget so you know how much money you really have to work with.
Cash Flow Budget
Your cash flow represents the net amount of cash coming in and out of your business. When it comes to shareholders, a company’s value is determined by its ability to generate positive cash flow.
Your cash flow is basically your operating budget minus all expenses and after you pay taxes. If you have a positive cash flow, that means you’re building cash reserves that will allow you to re-invest in your company.
Types of Cash Flow
Your cash flow is further broken down into three segments:
Operating Cash FlowThis includes all the cash you generate through the primary business activities of your company.
Investing Cash FlowThis includes all cash flow generated by investments in other ventures and the purchase of capital assets.
Financing Cash FlowThis includes all the proceeds you gain from issuing equity and debt, as well as payments you make.
In general, if you’re trying to assess your company’s profitability, you’ll look not just to cash flow but to free cash flow (FCF), which is the cash your company generates after all cash outflows to support capital assets and operations have been deducted.
FCF gives you a better picture of a company’s potential profitability than net income does because FCF takes into account the money a business is spending to pay off debts, buy back stock, and pay dividends to shareholders. You can also look at both levered and unlevered FCF, with the latter being the amount of FCF before you consider its financial obligations (like interest it must pay).
Analyzing Cash Flow
If you are looking for a way to analyze your cash flow, the debt service coverage ratio is most often used. This is your net operating income divided by your short-term debt obligations (or “debt service”).
The number this formula generates tells investors and creditors if the company can cover its short-term liabilities with its current cash and cash-equivalents. As such, investors always run these numbers before putting money into a business.
Are you looking to undertake a new project or investment? Then you need to look into your capital budget. Capital budgeting is a process used to assess a potential project or investment’s lifetime cash inflow and outflow. Those numbers will be used to help you determine whether the potential returns are sufficient to justify your investment.
You can use a capital budget in your personal finances to determine if a property or other purchase is worthwhile much the same way as a business uses capital budgeting to make smart business moves. The process is also called “investment appraisal” and it’s a big part of financial wellbeing.
How A Capital Budget Works
A capital budget may sound tough to create, but it’s worth every second you put into it. There are a few different methods you can use in creating a capital budget, one being throughput analysis. Others include net present value (NPV), discounted cash flow, payback period, and internal rate of return.
Generally, businesses will pursue any project that will increase shareholder value. However, since you are working with a limited amount of capital, using capital budgeting will help you make the most of the capital you do have available for these investments and ensure you yield the best return.
Understanding The Capital Budgeting Methods
Since throughput analysis is among the most popular capital budgeting methods, let’s take a quick look at how it works. It’s among the most complex forms of capital budgeting, but it’s also the most accurate.
With this method, your entire company will be combined on paper as a single profit-generating system. Your throughput will be measured as the amount of material passing through your system. This method assumes that almost all of your costs are operating expenses and that you need to maximize your throughput to pay for those expenses.
This method focuses on bottlenecks, which are resources in the system that require the most time or investment for you to operate. In other words, throughput analysis helps managers place a higher priority on projects that will reduce bottlenecks and increase related throughput.
Another method is DCF analysis, which stands for “Discounted Cash Flow.” This method looks at your initial cash outflow and how much you’ll need to fund the project. It will also project future cash outflows relating to the project’s maintenance and other costs.
All costs except for the initial outflow are discounted to the present date and the resulting number is the NPV, or Net Present Value. Projects with high NPV rank above those with low NPV, giving them higher priority when you’re deciding which to pursue.
Finally, there’s payback analysis, which is the simplest way to handle your capital budget analysis, albeit the least accurate. It’s widely used since it’s so quick to complete and it gives managers a basic understanding of a project’s real value.
This analysis calculates how long it will take to recoup the investment costs, with the payback period identified by dividing the initial investment by the project’s projected average yearly cashflow.
Budgeting For Success
As a recap: What are the 3 types of budgets?
- Operating Budget
- Cash Flow Budget
- Capital Budget
By using these 3 types of budgets you will be setting yourself up for financial success. Some people find they can better stick to their budget with a certain payment method. If you need help, reaching out to a certified accountant is a good idea. They can sit down with you, walk you through the various budgeting methods, and help put you on track to a healthy financial future.