Startup Financial - How To Create A Forecast and Budget
Your forecast and budget is your lighthouse. While you’re away at sea, trying to find a path forward in pitch darkness, your forecast and budget is a blinking light in the distance. It’s where you need to go.
What is a forecast and budget?
A forecast and budget is also called a pro-forma statement. It is a plan for the next year quantified into dollars. it’s a form of cash management. The forecast estimates revenue, while the budget sets a limit for how much you can spend. If you want your startup to survive the first few years, a forecast and budget is a critical part of that foundation. Without one, you might as well be blindfolded in a dark room searching for a black cat.
When do you forecast and budget?
A good place to start is one to two months before the year ends. Larger companies start much sooner so adjustments can be made and assumptions can be fully discussed and reflected in the numbers.
Bake in enough time for the finance team to work with other teams like marketing, HR, operations, etc. to come up with a business plan. Your business plan could be for the next 12 months, though many companies forecast and budget out for the next 3 years.
Startups use forecasts and budgets as a tool to decide what future projects to take on and plan out how they’ll contribute to revenue goals and keep expenses on track. For the right outcome, all teams need to agree on the goals and own what role they’ll play to achieve them. From there, you’ll need to get final approvals on your forecast and budget, and include any revisions to reflect upper management’s or board members’ expectations.
You may have to revise the forecast and budget each quarter, to reflect the recent circumstances and new strategies. Then get the buy-ins from every team and board members, and adjust as you go.
What are the tactical aspects of making a forecast and budget?
First, make a decision on which approach to take when making a forecast and budget: either top-down or bottom-up.
Taking an approach: top-down or bottom-up?
A top-down approach means top-level management creates the forecast and budget. They come up with the vision for the new year and communicate it out to the teams. They also give teams specific revenue and expenses targets that they’ll need to hit.
A bottom-up approach means teams create the forecast and budget (aka employees). The same team comes up with goals and plans for the new year, and use that to build the forecast and budget.
There isn’t a right or wrong way here. It all depends on what stage the startup is in and management style. Many startups prefer a hybrid approach, which incorporates input from management and the team.
How to create a budget:
1. Find a useful template
If it is your first time creating a budget, it’s easiest to start off with an online template. If your startup is over a year old, use last year’s P&L as a starting point.
All budgets are grounded in two major parts:
cash inflows (revenues, investments, borrowing, etc.)
cash outflows (expenses, debt repayment, buying fixed assets, etc.).
If your outflows are larger than your inflows, you’ll either need to cut spending, collect cash from customers faster, or borrow money. You and your team should list out everything you’ll need to spend money on. For example, expensive lab equipment, conference exhibitor fees, etc. The most important part about budgeting is adding detailed assumptions for each line item and calculation. These assumptions must be as realistic as possible. Each item in your budget should help you understand each amount (how much) and the timing (when it’s needed).
Add any new projects into the template and incorporate seasonal trends. If you’re feeling fancy, you can create different scenarios with your financial model (forecast and budget).
2. Each team owns an area
In order for forecasting and budgeting to be useful, each team should own a piece of it, defining the budget and forecast for their projects. For example, the sales team takes on the revenue part of a forecast and budget for their projects, while the marketing team figures out their marketing expenses. Once everyone is on the same page, each team makes sure their projects and plans contribute to the overarching goals of the company. Then, the management team does a final approval on what projects will launch the coming year.
3. Check actuals vs. forecast and budget
Once the forecast and budget are approved by management and the board, you’re ready to kick off your projects. Now the trick is to stay on track.
After the first month, check what the actual numbers are on your P&L. Then compare those with the numbers in your forecast and budget. Look hard at the differences and come to understand what doesn’t match up, what worked, and what didn’t. This is a crucial step in the process. If revenue grows faster than expected, find out why that is so you can keep it up. If growth is slower than expected, take a look at what needs to change.
If spending is higher than what was allotted in your budget, see where the extra money went. Can you cut expenses during the second month to make up the loss? Brainstorm with the team, learn from the past, and redefine the strategy to better position your startup. The most important part of a budget is to learn from it and improve it as you go. “Why?” is the most powerful question you can ask and how you create a path forward.
A CPA’s 2 Cents
Make sure to include how much funding you’re looking to raise in your forecast and budget. Use it to flesh out different scenarios as the timeline and amount of funding changes.
Based on the forecast and budget, you’ll get answers to key questions:
- Are the assumptions about growth rate sustainable?
- Is it really a true representation of recurring revenue? Or is it one-off revenue?
- How much needs to be spent to increase revenue?
- Is there a model for the relationship between marketing/sales spending -> customers -> revenue?
The forecast and budget guide the success of a startup, it will show whether your company is on the rise or on the decline.
Set a long-term vision for the startup, pick an effective approach to forecasts and budgets, align on resources, create a business plan that excites everyone, and iterate on your strategy as changes occur.
