Despite a global pandemic and one of the worst economic downturns in modern history, startup businesses continued to grow at a rapid rate in the United States in 2021. Although there are no final numbers yet at the time of this writing, new businesses starting in 2021 will almost certainly eclipse the record-breaking total of 4.4 million new businesses created in 2020 — the highest total on record and a 24% increase from 2019 (U.S. Census Bureau).
These trends were reflected in the number of ND entrepreneurs and small business owners who requested assistance from the ND SBDC. The SBDC served a record high 1,800 clients statewide, a 20% increase over 2020 and an 80% increase over 2019.
Unfortunately, we also know that not all of those businesses will survive. Approximately 20% of all small businesses will fail within their first year, and only one in two will be around in five years. Creating a financial plan and budget play a key role in small business success in every business stage but especially during the ‘existence’ and ‘survival’ stages. Poor cash flow management is a primary reason for business failure. That’s why it is critical for businesses to develop an annual budget and budgeting process.
The budget acts as the foundation for the business’s financial decisions. It helps businesses predict incoming revenue, variable and fixed operating expenses and changes in cash flow, which may require strategies to reduce costs or seek additional outside capital, before they happen. That’s why it’s critical to create a budget that can set you up for success.
Below are some budgeting mistakes that your company should avoid, along with a practical five-step budgeting process which you can implement to make your business more resilient.
Common Budgeting Mistakes
1.Create a budget for only recurring payments
Businesses often make the mistake of creating a budget that only includes recurring payments. Unfortunately, ‘surprise’ one-time expenses or certain onetime annual payments can hit, affecting company cash flow. Be sure to map out, plan and budget for those one-time expenditures.
2. Not planning for emergency costs
Successful financial planning also requires building an emergency fund, which will help you survive a crisis. If you don’t plan for emergencies, your business can suffer. Similar to our household budgets, I recommend working toward having a safety net equal to at least three months of operating expenses. It may take some time to build sufficient cash reserves, but an emergency fund allows you to avoid going into debt just to pay for these unexpected yet necessary expenses.
3. Failing to track your spending
Monitoring your expenses involves keeping tabs on your overhead during the month, and even daily. If you don’t keep track of your costs, you risk frivolous or impulsive spending, which may lead to a failure to reach your financial goals. Finding an effective method to track your expenses is critical, even if it’s in a separate notebook or spreadsheet.
4. Not automating payments
When trying to be responsible with your finances, the last thing you want is a missed due date. Not only is it bad for your credit, but it also results in late fees and additional charges. Unfortunately, this is a common mistake. Make sure to set up automated payments wherever possible to ensure that bills and other recurring expenses get paid on time every month.
5. Setting an unrealistic budget
When creating a budget and making financial plans, think realistically about what you can achieve with your limited income. For example, don’t plan to buy big-ticket items within a few months if you can barely save any money from rent and other necessary expenses. Instead, take it slow and be prudent with your approach to budgeting.
Budgeting Process Best Practices
1.Have a Written Plan
The first step in the budgeting process is having a written plan. It’s important to build a financial plan around your business goals. A plan is simply a tool and road map, which lays out the objectives, goals and strategies for achieving those goals. Organizations that stay focused on the plan know where to allocate their financial resources and, just as important, where not to spend money.
2. Develop Annual Business Goals
Annual goals should align with the priorities and initiatives outlined in the plan. These goals should drive the budget so company resources are aligned with and support the organizational strategy. The budget ensures the resources needed to achieve the goals. Make your goals SMARTspecific, measurable, achievable, realistic, time-bound and assign accountability for achieving the goals.
3. Develop Annual Budget
Prepare a 12-month projected income statement and cash flow statement.
The projected income statement should include:
- Projected revenue
- Variable costs
- Fixed cost
- One-time operating expenses
- Costs for new or special projects\
Establish a pre-tax net income goal to allow sufficient profit margin to be reinvested in the operations and growth of the business (retained earnings), or as dividends for the business owner or investors. Most established businesses desire a pre-tax net income of 10-20% of sales.
While profitability is an important measure of success, cash flow will determine the survival of the business and capacity for growth. A cash flow statement is an explanation of how much cash your business brings in, how much cash it pays out and its ending cash balance per month. The cash flow statement helps you understand your actual cash position.
4. Review and Evaluate Results
The owner and/or leadership team should monitor performance by reviewing company financial statements on a monthly basis. Evaluate and discuss how the company performed compared to budget, previous period and the same period the previous year (horizontal analysis).
Then, look at the percentage of each component in relation to the total within that financial report (vertical analysis). For example, on the income statement each item should be stated as a percent of sales such as gross profit margin as a % of sales.
The company should also look at its performance vs. industry (benchmarking), especially if the company is a young company without several years of history. Be sure you are comparing your company to similar size companies in the same industry (NAICS code). Also, be sure you are getting your industry data from reputable sources.
Note any significant variances (variance analysis). It’s important to identify what’s causing the variance and the potential impact before you can correct it. Use dashboards or dynamic spreadsheets with conditional formatting and color coding to make it easier to spot variances.
5. Make Adjustments
Use your variance analysis to adjust where needed. Unless you are a start-up business with no history, I would recommend not changing your budget during the year. It is important to go through this analysis every month, rather than waiting until the end of the year, so there can be course corrections if needed.
7. Use Online Budget Planning Software
Budgeting tools can help automate and standardize processes while minimizing the chances of errors in your budgeting. Some accounting systems such as Quickbooks Online have integrated budgeting functionality. Otherwise, you should look for a budgeting app that can be integrated with your accounting platform.
Several common accounting and/or budgeting solutions include:
- Quickbooks Online
- Zoho Books
- PlanGuru (budgeting app only)
Having a solid budgeting process is foundational for sound business management, growth and long-term sustainability. The beginning of a new year is a great time to put a budget process in place.
If you would like assistance with creating a budget or have questions regarding other areas related to starting and managing a small business, please seek help from the ND Small Business Development Centers (SBDC), another SBA resource partner or business advisor.