Autumn is upon us once again, and that means it’s time for three things: shorter days, pumpkin flavoring in everything, and figuring out next year’s budget.
If you’ve never made a business budget before (or if your business has gotten significantly more complicated than last year), it’s not always clear what to do or where to start. To help you get going, we’ve put together a quick guide to annual budgeting for startups.
Before we get into the execution, let’s take a moment to talk about the why. What is the purpose of the annual budget, and why is it important?
Besides just avoiding a cash crisis, your budget is an important tool for answering these questions and helping better understand your business.
Since your budget is for the entire upcoming year, you’ll need to forecast how you expect your business to perform for the next twelve months. That’s why when you sit down to start your annual budgeting process, it pays to carefully think through your plans for the upcoming year, and how they might affect your income and spending.
Asking the right questions before you start is key to a successful budget. Make sure you’ve covered everything with our free Annual Budgeting & Forecasting Checklist.
When you start actually assembling your company’s budget, there are essentially two parts of the equation: inflows (the amount of money you expect to bring in) and outflows (the amount of money you expect to spend, whether it’s on creating the product or day-to-day operations). The end result might look something like this:
Let’s take a deeper look at what each section means.
Revenue. This is your company’s income. Usually this means money from sales, though if you have income from other sources (rent from property your company owns, licensing royalties, etc) that money will be included here also.
If your business sells subscriptions or services, you should also include your annual recurring revenue (ARR). This is the amount of money you receive from your subscription contracts, divided by the length of the service contract. For example, if a client buys a 3-year subscription from you for $6000, your ARR for that client would be $2000 ($6000 divided by 3 years equals $2000 per year). While this does not directly go into your financial statements, it’s a great KPI to keep an eye on if you’re a SaaS business.
Cost of Revenue / Cost of Goods Sold (COGS). This accounts for how much you had to spend to create your product or service. For companies that sell physical products, raw materials and labor costs are considered part of COGS; for companies that sell software or services, COGS include any costs directly associated with providing the software or services to your clients, such as the cost of hosting servers. Note that promotion costs like sales and marketing are not included in COGS – these will be accounted for elsewhere.
Gross Profit. This is the amount you make in profit from your sales, before any other costs or expenses are added in. To calculate it, subtract your COGS from your revenue. The amount left over is your gross profit.
While your actual profits will be lower (due to additional costs like operating expenses and taxes) , gross profits are useful for determining how efficient you are at creating your product. If your gross profits are low, it’s a sign that you might want to investigate ways to lower your COGS or increase your revenue.
Payroll Operating Expenses. This category covers any expenses related to paying your employees. Besides just salaries, this includes health insurance, PTO, payroll taxes, and the costs of any other benefits you offer your employees.
Non-Payroll Operating Expenses. Any money you spend normally running your business that isn’t related to employee compensation is listed under this category. This includes everything from rent and utilities to marketing and R&D costs.
Operating Income/Loss. This is one of the most important lines on your budget: the one that tells you if your normal business operations are making or losing money. To get this number, subtract your total operating expenses (payroll + non-payroll) from your gross profit. If the number is positive, your business is overall generating income. If the number is negative, then you’re operating at a loss.
Most startups aren’t profitable until after several years, so an operating loss here won’t be a surprise. This number is still valuable, however, because it allows you to understand how your company is currently operating (and track if it’s following your plan).
Net Income/Loss. This is your total income or loss, after all expenses have been subtracted from your gross profits. If you don’t have any additional costs outside of your operating and capital expenses, this might be the same as your operating income/loss. If you do (for example, if you owe state franchise taxes), your net income will be your operating income, minus those remaining expenses.
Note that this is not necessarily your “cash burn,” because the financial budget (especially if your books are done on an accrual basis) does not reflect the exact inflow and outflow of cash. The timing around when your customers pay you and when you pay rent, for example, can all contribute to your actual cash burn.That’s one of the reasons why annual prepayments can be so helpful for startup cash flows.
Unsure on how accrual books work? Get the details on cash vs. accrual accounting.
So now you know what to plug into your budget, but where do those numbers come from?
Your business’s financial statements are your starting point to get the data you need to build your budget. Each statement provides different information to help you:
Guessing the future is always tricky, and it’s rare for anyone to get it 100% right. What you can do is take steps to make an especially-educated guess.
Annual budgeting is a complex task, even for experienced business owners. Getting expert guidance can make a big difference in how effective your budget will be, and how quickly it comes together. If you don’t have a background in finance, it can be worth it to get help from someone who does.
This doesn’t have to mean making an expensive senior finance hire. Many financial service providers, including us at Pilot, offer outsourced CFO services that give you access to an experienced CFO when you need it. Working with a fractional CFO is a cost-effective way to get expert input on what’s important to your business, and how to construct a budget that will help you grow.
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