The first is always document all your assumptions used to prepare the figures no matter how trivial they are. This means showing items such as VAT rates, PAYE/NIC rates, debtor collection days, creditors payment days, stock turn over days (if applicable), depreciation rates, how sales were calculated, how the gross margin was calculated. This is not an exhaustive list but it will give you an idea of the assumptions to be included.

The second is opening balances. To complete the balance sheet and to have a complete picture going forward, the opening balances for the budget year which are the closing balances of your financial year will need to be inserted into the balance sheet. The budget will now be complete.

Remember to review your budget to ensure it makes sense and there are no gaping holes. Also you will need to interpret the results to gain an understanding of what the budget means. The profit and loss account will show when profitability attains breakeven and the cash flow forecast will highlight if more cash is needed to keep the business going or if there is surplus cash to invest in the business.

If you have any questions regarding any of the blogs on budgets, or if you need any help in preparing your annual budget then please do not hesitate to contact me.

As the budget balance sheet contains a lot of information the structure of the cash flow forecast is quite simple in comparison as it is broken down into receipts and payments.

Receipts consist of:

* Trade debtors (all sales) – taken directly from the balance sheet;
* VAT (if in a repayment situation) – taken directly from the balance sheet;
* Sundry receipts – one off receipts not passed through the sales ledger; and
* R&D tax credit – if eligible.

Payments consist of:

* Trade creditors (all purchases, expenses, stock and fixed assets) – taken directly from the balance sheet;
* VAT (if owed to HMRC) – taken directly from the balance sheet;
* Net salaries – taken directly from the balance sheet;
* PAYE/NIC – taken directly from the balance sheet; and
* Sundry payments – one off payments not passed through the purchase ledger.

To calculate the cash balance at the end of each month:

Opening cash balance + Receipts – Payments = Closing cash balance

If your closing cash balances at the end of each month for the duration of the budget are positive then there should be enough cash in the business to keep the business operating.

However if any of the closing cash balances are negative then you may have to find ways to turn these closing cash balances positive by increasing sales, cutting costs, factoring invoices or negotiating new credit terms with customers / suppliers. If this cannot be done then you may have to find ways of attracting new investment into the business or maybe taking out a short term loan. Please remember there will be costs associated with both these types of funding and these will have to be reflected in the budget.

This may all sound like doom and gloom, but by creating the cash flow forecast in the budget you have time to plan and be proactive in finding ways to fund the business rather than having to react when the cash runs out and there is no way of saving the business. I have seen both these scenarios for businesses I have worked for in the past. Even though being proactive and finding new investment can be stressful and uncertain believe me, when I say it is not as stressful as seeing a business running out of cash, people being made redundant and not being able to do anything about it.

Planning helps you take control of the financial future of your business, so take control rather than leaving everything to chance and then being sorry as it will be too late.

Once purchased the fixed asset is recorded in the fixed asset register and the general ledger. It is depreciated at the rate of the asset category it has been assigned to. The depreciation is calculated monthly and the depreciation charge is charged to the profit and loss account and offset against the cost of the asset on the balance sheet.

So why are we talking about depreciation? Well we need to include depreciation in our budget profit and loss account (as it affects the bottom line) and balance sheet and therefore we need to project the depreciation for each asset over the coming year. Depreciation is known as a “non cash item” so it is never included in the cash flow forecast but it is offset against the cost of the asset so the asset is valued in the balance sheet at its net realisable value i.e. its open market sale value.

To compile a capital expenditure budget you need to list all the items which are likely to be bought over the coming year and allocate them to the month they are to be purchased. It is best to have a minimum limit for each item e.g. £100 to £250 otherwise the list could be endless. To be safe it is probably best to add a contingency as you never know what you may have to buy e.g. a new computer. The depreciation should be calculated for the items included in the capital expenditure budget on a monthly basis. The capital expenditure budget will then be inserted into the balance sheet and the cash flow forecast and the budget depreciation in the profit and loss account and the balance sheet.

Having included the capital expenditure budget into the budget model you may find there is not enough cash in the cash flow forecast to pay for the capital expenditure. At this point it may be worth considering if leasing certain assets might be a better option as it will spread the cost over time, which means your cash lasts longer, rather than being spent in one go.

To calculate the trade debtors we took the sales figures from the profit and loss account and added VAT. This calculated VAT figure needs to be entered onto the VAT line as a credit to complete the double entry for trade debtors.

Calculating the trade creditors figure is a little more complicated as trade creditors includes a number of elements which include:

* The purchases figure from the stock (inventory) on the balance sheet (see previous blog);
* Expenditure from the profit and loss account excluding salaries; and
* Fixed asset purchases from the balance sheet (fixed assets are accounted for net of VAT with the exception of company cars).

VAT is added to all of these to calculate the trade creditors figure and the VAT is entered onto the VAT line as a debit to complete the double entry for trade creditors.

In January 2011 the VAT rate was increased to 20%. As budgets are forward looking then the rate used will need to be 20%. VAT returns are completed quarterly and the budget must reflect this. VAT is paid in the month following the end of the quarter, so the VAT payment will need to be added to the cash flow forecast in the month following the end of the quarter and the VAT balance on the balance sheet cleared down to zero. If however your business completes monthly returns and is in a repayment situation then the VAT receipt will be added to the cash flow forecast in the following month and the VAT balance on the balance sheet cleared down to zero.

A couple of things to remember are:

* VAT is not added to any of the numbers included in the profit and loss account; and
* When you add VAT to your sales, purchases, expenditure and fixed assets the calculated VAT figure must be inserted in the VAT line of the balance sheet to ensure that the double entry is completed.

One of the items included in the expenditure section of the profit and loss account which is treated differently in the balance sheet is salaries. The salary figure included in the profit and loss account is the gross salaries plus the employer’s national insurance contributions (NIC). However people are paid their gross salary less PAYE less employees NIC. Therefore we have to split the gross salary between the net salary, PAYE and employees NIC. The easiest way to do this is assign 70% of the gross figure as net salary and 30% as the PAYE and employees NIC. The 70:30 split is arbitrary so you may find a percentage split which suits your business better.

On the balance sheet it is easier if you have two accounts for salary costs. One is for the net salary which is the 70% of the gross salary and the second for the 30% of the gross salary representing the PAYE and the employees NIC. The employer’s NIC is added to this account. The reason for the split is because the net salary is paid in the month before the PAYE and national insurance. PAYE and NIC are paid to HMRC on the 19th of each month. The split makes it easier to allocate these payments into the correct months in the cash flow forecast which is integrated with the profit and loss account and balance sheet.

Similarly employee pension contributions have to be deducted from the gross salary and kept in a separate account with the employer’s contributions as they are likely to be paid over to the pension companies on a different date each month from the net salaries, PAYE and NIC. The treatment is exactly the same as for NIC.

The treatment of salary costs can appear complicated and people often become confused. My understanding came when I was training to be a Chartered Accountant and very often we produced T accounts to make sure the reconciliations were correct. Do people remember/still use T accounts for difficult reconciliations?

To calculate the profitability we took:

Sales – Cost of sales = Gross profit – Expenditure = EBITDA

EBITDA = Earnings Before Interest, Tax, Depreciation and Amortisation.

Please note that as the profit and loss account is being compiled remember to list the assumptions used to calculate the figures at the same time as they may have to be referred to.

To start building up the trade debtors (accounts receivable), trade creditors (accounts payable) and stock (inventory) in the balance sheet we now have to feed figures into the balance sheet from the profit and loss account.

VAT is added to the sales from the profit and loss account and sales + VAT are put into the balance sheet as trade debtors. If the customers’ terms are 30 days then the trade debtor is translated to cash in the next month and the trade debtor is removed from the balance sheet.

Cost of sales where there is no stock and expenditure with the exception of salaries (to be discussed later) will be treated in a similar way. VAT is added to the expenditure from the profit and loss account and expenditure + VAT is put into the balance sheet as trade creditors. If trade creditors are paid on 30 days terms then the trade creditor is removed from the balance sheet in the next month.

Stock is included in the balance sheet net of VAT. To calculate stock purchases:

Closing stock + Cost of sales (profit and loss account) – Opening stock = Stock purchases

NB You will need to determine what the level of closing stock should be.

The purchases are treated in the same was as expenditure as discussed above by adding VAT and including them in trade creditors.

So far I have shown how to calculate the trade debtors, trade creditors and stock on your balance sheet. There are other areas of the balance sheet which still need to be looked at and these will be discussed later.

This may include plans for expansion or closure and these would include costs for:

* moving
* refurbishment of the premises
* rent, rates, service charges, light and heat, insurance etc
* new furniture and machinery (not treated as capital)
* rental break costs from the old premises (if any)
* dilapidation costs for the old premises (if any)
* contingency costs as some incidental costs will arise

For most companies salary costs account for about 50% of expenditure and so it is important to include all the new staff you are likely to recruit over the next year. You will need to determine the costs associated with each new employee which not only includes their gross salary and employers NIC but also:

* any benefits
* recruitment costs
* training
* new computer
* new desk

Other costs to be considered to build up the complete cost base include:

* Marketing costs – will you be attending any exhibitions?
* Travel costs – which members of staff travel and how frequently?
* Research and development costs – allocate these to individual projects.
* Distribution and logistics costs – if relevant.
* Facilities costs – include all items from rent and rates down to the tea and coffee for the employees.
* Office costs – this will capture costs not included elsewhere such as communications and IT.
* Corporate costs – legal, audit, accountancy and tax fees and directors’ fees.
* Interest costs.

Remember to include all expenditure including expenditure associated with any planned changes to the business. Even though many costs will be estimates this will give you a good picture of the profit or loss for the business for the coming year.

With a start up business you will need to look at the potential markets for your product, the number of units expected to be sold (over the products lifetime) and the sales price of the product. By this point you should know if you are manufacturing / buying the product or licensing your technology to a third party and receiving royalties. In both cases you need to document your assumptions to determine your sales for the coming year. If you are manufacturing / buying in your product for resale will you be able to order / buy enough units to reach your sales targets or will you need alternative manufacturers? Have you calculated the cost of your product and do you know whether the product will have a profitable gross margin? If your gross margin is negative is this product ever going to be profitable?

For businesses with established product ranges you need to calculate the gross margins for each product and if any of these are found to be unprofitable then you should consider whether these products should be discontinued. This can happen when a product reaches the end of its life and the sales price drops below the cost. Also with more established businesses the sales budget should be analysed by customer as there may be the potential to make more sales, likewise the budget can be analysed by geographic sectors as emerging markets may have more demand for a product when sales are starting to drop in established markets.

What the budget does is to help management identify their plans for the next financial year and the budget helps to crystallise these plans by documenting them and working out how much they will cost. It means that a business is not standing still and it is looking to the future to improve its profitability, cash flow and net worth.

So what does the budget include? The budget is usually split into twelve months (it can be weekly) and it should include:

* a profit and loss account;
* a balance sheet;
* a cash flow forecast; and
* a list of assumptions.

All departments should give their input and the budget should be agreed by the management team and signed off by the board of directors, so that everyone buys into it. So if you want to crystallise your plans for your business for the next financial year and you want everyone to buy into your plans do you think a budget would help you?

A cash flow forecast helps you to be proactive in your business so you can start to plan your short term cash requirements, as the forecast is a rolling three month forecast. The forecast needs to be updated each week with the actual transactions which have been cleared by the bank and then the forecast is extended for another week to keep the three month forecast. Once the cash flow forecast is up and running it does not take much time to update it each week as long as it is kept up to date. In addition CEOs like to see the weekly cash position so they can plan for the short term so what is stopping you from setting up a weekly cash flow forecast?

So if you want a tool where you can forecast your cash balance for the next three months on a rolling basis and you want to be proactive when it comes to your cash situation rather then being reactive why not set up a weekly cash flow forecast. If you need any help or advice on this then please let me know.