Remember when you first started your business and persuaded your bank manager to give you financial backing? Regardless of how persuasive a salesperson you are, you probably succeeded because you had a good business plan and a budget. Yet a surprising number of business owners soon drop the budgeting process. They seem to think that the year’s financial performance is the best they could have achieved, regardless of whether they set a budget or not. This is simply not true.

Budgeting can be as simple or complex as you want it to be, and there are many good reasons why you should prepare a budget.

It's a tool for putting your financial objectives into context
In general, business budgets relate to either your planned financial performance (ie sales and profitability) or the cashflow resulting from that financial performance.

The bank is usually concerned with your cashflow, because it indicates your ability to pay your creditors and therefore tells them how safe their money is. But business owners want to know whether they are making money or not, so are more interested in sales and profitability.

The budgeting process gives you a tool for forecasting sales, costs, profits, and consequently, your cash flow.

Budgeting identifies financial problems early and helps decision making
When the profit and loss or cash flow budget has been prepared, it will highlight potential financial problems. For example, if you know that sales always drop in certain months, your budget will show the effect on profitability and, consequently, cash flow. The economic factors might be beyond your control, but by identifying when they might occur and what their impact will be, you at least have the chance to develop contingency plans.

Furthermore, because the budget tracks data over time, examining it might highlight a gradual increase in overheads. You can then estimate risk of your overheads becoming excessive, and can take cost-cutting measures in good time.

It lets you compare actual performance against anticipated performance
Only by preparing a budget for a particular accounting period, can you then compare actual performance against the budget and work out whether you have achieved what you setout to do.

However, you should remember that budgeting is a continuous process. So for example, if you have compared actual performance against budget for the first two quarters of the year, you should consider how any variance will affect the remaining quarters and amend the yearly budget appropriately.

There will be no benefit in simply demonstrating that actual performance is considerably better or worse than budget. Budgeting is not a theoretical exercise – action must arise from that comparison. Whatever action you take will be determined by what you want to achieve (ie your business plan and goals).

… and finally, budgeting motivates both owners and employees
Although staff motivation will never be the main reason for preparing a budget, you can see a dramatic improvement in morale if you set a budget that is stretching but still achievable. Care should be exercised because an unrealistic budget will be correspondingly de-motivating. Remember also that if the budget is intended to motivate staff, then they need to be able to contribute to and influence its achievement.

No business operates in a vacuum. Both macro and micro economic factors influence how successful it will be. Although budgeting will not affect these factors, it can let you manage their impact. It will hopefully be obvious that budgeting is a central part of the business planning process, and in the current economic climate, it could be the difference between surviving the downturn or not. As the saying goes, failing to plan is planning to fail.

Paul Hickson is a Partner at Menzies. If you need help preparing a budget for your business please e-mail Paul (phickson@menzies.co.uk) or speak to any Menzies partner.