Developing a Cash Budgets and Internal Rate Of Return for Capital Budgets
Budgets are financial plans − plans for how businesses will operate, how money will be spent, how income and revenue will be received… a good budget allows 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. Let's take a closer look at both.
If you're not familiar with business budgets, a cash budget is similar to a household budget. The main value of a cash budget − aside from serving as a forecast for the overall health of a business − 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. Let's take a closer look at estimated sales and expenses, since those items make up the bulk of a cash budget.
Estimated Income and Expenses
Cash budgets estimate income you will receive and expenses you will incur during a specific time period. Estimating income (sales) is the foundation of a cash budget; once you have that number, many expenses naturally follow. The problem is, of course, that 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.
For more information on sales forecasts, check out the article Financial Forecasting .
Estimating expenses can be a little more time-consuming but is relatively 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 could look like (in simple terms):
Time Period: January 1 through December 31
|Cash On Hand:||$20,000|
|Sales of products||$200,000|
|Sales of services||$55,000|
Keep in mind the above is a simple example of what a budget could look like. Each line item could contain a number of sub-categories; other major categories like depreciation and interest expense have been purposely omitted. Also note that a cash budget looks a lot like an Income Statement (for more information about income statements, check out the Income Statement article). The main difference is an Income Statement provides detail regarding actual business results; a cash budget attempts to predict future results.
Cash budgets can and should change over time, especially as you develop a history of actual sales and expenses. The more historical data you have on hand the more accurately you can predict future events.
A capital budget is a tool used to plan major, long-term, cash-intensive projects like building new facilities, purchasing major equipment, or funding long-term research. Unlike cash budgets, capital budgets are light on estimates and heavy on financial analysis. Most businesses use one of several financial tools − Internal Rate of Return (IRR), payback period, and Net Present Value (NPV) analysis − to determine if a capital expenditure makes solid financial sense.
Let's look at each tool; keep in mind the goal of this description is not to teach you the formula, but to provide an overview of each approach.
Internal Rate of Return (IRR)
IRR is used to predict the potential of a capital investment based on future cash flow. The theory behind IRR is that capital projects will create negative cash flow in the beginning (when money is spent to fund the project) and later should create positive cash flows (as the project results in additional sales or income). The higher the IRR, the better the project is estimated to perform. Since IRR is expressed as a percentage, it is easy to evaluate one project against another to determine which generates the greater return.
The payback period is the length of time required for an investment to pay for itself. For example − discounting the effect of interest or the time value of money to keep things simple − a $4,000 investment that returns $1,000 per year has a four year payback period. Shorter payback periods are better than longer payback periods. For more information on payback periods, see the article Break-Even Analysis.
Net Present Value (NPV)
Net Present Value evaluates the future dollars a project will generate using the current value of those funds. In other words, dollars received in the future are worth less than dollars received today. NPV takes into account the time value of money. NPV calculations estimate the amount and timing of project cash flows, then discounts future cash flows to determine a present value.
A key factor in NPV calculations is the hurdle rate. The hurdle rate is the minimum acceptable return on an investment. Different companies use different hurdle rates, taking into account risk, availability of capital, sales projections, etc. In effect the hurdle rate is like an internal threshold helping to determine if a project makes sense.