Once a budget for revenue and expenses for the year is established (see last month blog, Flexibility-The Key to Sound Budgeting), I strongly recommend that you continue on and also budget for balance sheet items. To be honest, there was a time in my career that I viewed trying to budget assets and liabilities as a tremendous waste of time, and if the budget was stagnant and we missed our sales targets, it was! However, using flexible budgeting, you can build a budgeting model that ties the income statement and balance sheet. Even if you miss the sales target, you can still link assets and liability to revenue and expense accounts.
My favorite software for developing a budget model is MS-Excel®. Put all active asset and liability accounts into your model. It is important that all your revenue and expense accounts be linked to some account on the balance sheet. As an example, if you typically sell on open account with 30 days turnover, you must link to net revenue to accounts receivable. If you manufacture a product, you will need to build the purchasing and production cycle into your model. Materials will need to flow from raw inventory to work-in-process and through finished goods.
This process also provides the ability to create a detailed capital budget that includes the timing for your purchases. You can also tie depreciation expenses to accumulated depreciation. I’ve found that the process works best if you have separate lines for the beginning balance, debits to the accounts and credits to the account. When transactions are complex, you can add a line for each level of detail. Total the beginning balance, debits, and credits (credits should be negative numbers) together for the ending balance. Using the ”sumif” function makes calculating totals for balance sheet information easy.
Why is this useful? Imagine that you sell a product through a commissioned sales force that is paid 5% commission. By tying the commission expense to the accrued commission liability account, you can watch the liability go up with additional sales or fall on lower sales. That is the beauty of this process. Not only does this account reflect what happens in a “what-if” manner, but done properly, all accounts move up or down in relation to activity within the organization. Taken as a whole, companies can anticipate the future movement of asset and liability accounts based on reasonable assumptions. In total then, cash needs can be forecast. Anticipating future cash movement goes a long way toward managing cash and making sure your organization has the cash necessary to grow and be successful.
Using this information allows you to forecast the balance sheet by month. Once a forecasted balance sheet is in place, you can have your internal accounting personnel generate a formal projected statement of cash flows by month. This becomes particularly useful when you want to know the effect of reducing accounts receivable days outstanding or the effect of increasing inventory turns by a full turn annually. The changes created by these improvements become very visible and often this visibility helps drive organizations to realize these benefits.
If all this sounds like a process that would really help your company but you don’t know who or how to go about developing, our partners at B2B CFO® are experts at putting together business models. Our experience makes the process much easier for clients and provides a sound business tool that helps companies understand the effect of incremental changes on the business. Feel free to contact us.