Budgeting: A Means to an End

Posted by on Nov 28, 2013 in Budgeting and Forecasting

The truth is in the cash flow

Budgeting: A Means to an End

In my last post, I made the point that for a business to properly understand its cash flow it needs to pay attention to both its Profit and Loss statement and its Balance Sheet. It follows then, that when preparing a budget, a business needs to complete one that covers both its Profit and Loss statement and its Balance Sheet.

However, my experience has been that: i) the majority of those businesses which prepare a budget, only do so for their Profit and Loss Statement, and ii) there is a high level of resistance to preparing a budget amongst SME owners (and this experience is confirmed by the research, again see my last post).

Why is this so? My hypothesis is that: i) SME owners (and their advisers) may not have the necessary skills to produce a budget balance sheet, and ii) SME owners resist preparing a budget because of the inherent uncertainty involved in such activity.

Is there a solution to these issues?  I think so.

I’d like to first deal with the inherent uncertainty in preparing a budget. I’ll start by referring you to this column by Ross Gittens, an economist who writes for Fairfax. I have been reading him since 1983 and have found that he writes with simplicity and clarity about a subject that is not the most approachable.

This particular column deals with, amongst other things, the accuracy of the Reserve Bank of Australia’s forecasts for Inflation and GDP.  It summarises the results of a review by the RBA of its forecasting accuracy, based on the range of the actual forecast errors it made between 1993 and 2011. The column is an easy read, but for the time poor, the relevant and practical messages from it are:

The accuracy of the RBA’s forecasts is not particularly high.

Their experience is typical of that of similar bodies around the world. For example, The Treasury Department of the Australian Federal Government completed a review in November 2013 of its forecasting accuracy, and arrived at a conclusion that is consistent with the RBA. If you are mathematically minded you will find the Treasury paper interesting.  However, for most people, the key take-away will be in Treasury’s conclusion, that “rather than focussing on precise point estimates, a more nuanced discussion would acknowledge that uncertainty is an unavoidable feature of forecasts…”

Gittens makes the point that the RBA’s lack of accuracy is not a major issue because: i) the RBA revises its forecasts every quarter based on the actual GDP and Inflation results as they come to hand, and ii) the RBA usually adjusts its cash rate in an incremental fashion, thereby limiting the impact of getting it wrong.

Lastly, Gittens points out that the RBA is not afraid to change direction if it becomes obvious that it should do so.

So, what lessons can SME owners (and their advisers) draw from the experience of organisations that are arguably the best in the forecasting business? I think they are:

  1. Budgets are best used as a tool, constantly reviewed and adjusted for real world impacts, and  
  2. A budget is a means to an end, but not an end in itself.

I’d also add that a further practical benefit of the budgeting process is it requires the SME owner to identify the specific steps they need to take in order to achieve their budget’s outcomes.  This provides the SME owner with a context from which to make informed decisions when the real world intersects with their budget. It enables the SME owner to review whether they have taken all the steps they identified or whether some other factor has changed (currency, economy, competition etc). This context means the SME owner makes an informed choice when deciding whether and what action to take in light of actual results to date.

Addressing the skill issue is relatively easy. There are many avenues of help available to the SME owner.  The first port of call is their accountant.  Other possibilities include their business banker, or finance broker (if the business uses one). Certainly, the business banker has access to off the shelf software that can be used for forecasting both balance sheet and profit and loss statement. The better finance brokers will use similar software, but it may be necessary to pay them a fee. Finally, there are specialist businesses, like my own, with the capacity to help.

Put simply, help is available and there is little excuse for a determined SME owner not being able to find it.