Financial budgets and projections are two of the most important financial tools that are available to financial managers and entrepreneurs. Budgeting and forecasting are two of the most important financial processes and documents that an organization relies on.
This is part of the Producer vs. Entrepreneur series, but I’m diverging a bit and not getting into Producer or Entrepreneur specifics here, because budgets and projections are important to both. This is going to be more of a general look at budgets and projects that everyone needs to do.
What is Budgeting?
Budgeting refers to the allocation of costs to different departments, processes and sectors related to the business. Without making a budget an organization would simply not be able to manage its costs and revenues.
Budgeting allows managers of different departments to know exactly how much they can spend during any period. For example the production budget tells the production manager how much he needs to produce, how much raw material will be required, and what the demand is going to be. The production manager then draws up his working plan according to the budget.
Therefore every department will have its own budget. In most organization the cycle starts with the sales budget that signals the predicted demand. Using the demand the purchasing managers make up the purchase budget to requisition or purchase raw materials and then the production managers draw up their budget using the budgeted amount of raw materials.
In this manner, budgets from different departments are linked together. Budgets are also used to apportion various costs such as direct material, labor, overhead and other costs between all the departments according to the contribution.
What Are Financial Projections?
Projections are Forecasts on the business financials and are slightly different from budgets. Forecasts deal with future trends that the business expects. People have a tendency to mix up forecasts with predictions. A forecast is not a prediction. Think of a weather forecast, it is based on satellite data and complicated formulae, it is not a prediction made on guesses. Instead, a forecast is based on data but it’s not necessarily correct all the time. It actually often is incorrect, because things change.
Business forecasts work in a similar manner, they are based on the data available with the business, it is not necessary for a forecast to be correct all the time because businesses operate in a dynamic environment. For example, at the beginning of 2020, the financial outlook for the year was good and business activity was set to increase, however, the outbreak of COVID-19 caused all of the forecasts made to be wrong.
Nevertheless, forecasts are important as they help managers see future trends and then make decisions accordingly to survive. For example in January World Economic Forum predicted that the market for tokenized assets is going to increase to 10% of global GDP by 2027. This is a very important forecast for businesses and entrepreneurs that are looking to step into the tokenized assets market. Based on this forecast many investors and entrepreneurs will take high stake decisions.
Therefore forecasts and budgets both form the basis of how the business is going to allocate its costs in the short term and in the long term. While budgets cover at most the next year, forecasts can cover multiple years. As mentioned before forecasts do not have to be completely spot on, they are there to simply provide a glimpse into the future based on currently available data.
Investors and stakeholders who read these forecasts know that the forecasts can change if the underlying data changes. This is why most of the time the forecasts prepared by the organizations are attested or verified by third parties such as audit firms. Even in this case the degree of verification given only related to the authenticity of the underlying data.
If you look at the full set of published financial statements of any listed entity you will find that the financial statements contain a lot of analysis and projections to help the readers ad in particular stakeholders understand the performance of the business and it future growth potential.
Some of the most common ratios that are published for the financial analysis include
- Liquidity Ratio: This ratio shows the ability of the business to pay off its debts
- Profitability Ratio: This ratio shows the profitability of the business
- Gearing Ratio: This ratio shows the level of financial gearing, how much of the business is financed by debt and how much by equity.
- Earnings per Share: This ratio shows the level of dividends that can be given out per share. Investors in particular are interested in EPS as it tells them how much they can earn.
- Price-to-Earnings Ratio: This ratio signals to the investors the value of the company. Using the PE ratio, investors can determine if the shares of a company are overvalued or undervalued.
Apart from these ratios, the financial statements may also contain future projections and these projections are aimed at potential investors. Companies use these financial projections and analysis to show the performance of the organization and increase the confidence of stakeholders and investors.
Who Can Create Budgets and Forecasts?
Budgeting and forecasting is a highly specialized and technical area that requires professional accountants. Entrepreneurs generally have good business management and organizational skills but they are not highly qualified accounting professionals. Therefore if you are an entrepreneur looking to create budgets and forecasts for your business, then you need to hire a professional accountant.
If your business already has a dedicated finance function then your finance department must have the personnel with the required technical proficiency to create budgets and forecasts. If however you do not yet have a finance department or have outsourced it then you can either consult your outsourcing partner or any finance and audit firm to help you make up budgets and forecasts for your business.
If you’re looking for a way to keep your costs, revenue, and other finances straight, take a look at FreshBooks. It has a lot of great resources. I review the FreshBooks platform here.