Developing a Cash Budget and Internal Rate of Return for Capital Budgets
Budgets are short-term plans for how businesses will operate, how money will be spent, how income and revenue will be received. A good budget enables a company not only to plan, but also to react to unforeseen circumstances.
There are a number of different types of budgets; the most common are cash budgets and capital budgets. Here is a close look at both.
A cash budget is similar to a household budget. The main value of a cash budget is that it can indicate periods when "cash in" and "cash out" are out of balance. A cash budget is like a view of the future; it might protect your company from seasonal swings in cash flow, give you a sense of what expenses will be like under different business scenarios, and allow you to make decisions about hiring, expansion, and evaluate operations on a macro and micro level.
Cash budgets tend to be set up for at least one year, but you could choose to develop a cash budget for any time period that makes sense for your needs.
Cash budgets have three main categories. Two are easy to determine; the third requires a little work
- Time period. What time frame the budget covers.
- Estimated cash position. How much cash you wish to keep on hand at all times. How much cash you want to keep on hand depends on the type of business you run, the predictability of your cash flow (especially accounts receivable), and how often you feel opportunities may arise to make rapid investments or purchases of supplies, inventory, etc.
- Estimated sales and expenses. In simple terms, cash in and cash out.
The first two categories are, as mentioned, relatively easy to determine. The third, estimated sales and expenses requires a closer look, since those items make up the bulk of a cash budget.
Estimated Income and Expenses
Estimating income (sales) is the foundation of a cash budget; once you have that number, many expenses naturally follow. The problem is estimating sales requires some amount of guesswork, especially if you are starting a business and have no prior history to draw upon. If that's the case, your best bet is to create a series of cash budgets: One using a sales estimate you feel is most accurate, and then other budgets at different thresholds, like10% less than your best estimate, 20% less, 10% more than your best estimate, 20% more, etc.
Keep in mind that creating budgets for sales shortfalls is usually more important than creating budgets for best-case scenarios; while higher than anticipated sales can create problems all their own, most business owners are happy to deal with that type of problem. Creating a plan ahead of time for potential sales shortfalls could help you make quick decisions to keep your business alive.
Estimating expenses should be a little more straightforward. For example, if you plan to or already rent office space, you should know the rent, utilities, insurance, etc., ahead of time. If not, developing a cash budget will give you a good sense of what you can afford. The same is true for employee salaries, equipment needs, supplies, and other fixed expense items.
Here is what a cash budget might look like (in simple terms):