Knowing when, and how, to invest in your company’s future is a skill. Fortunately for new business owners, it’s a skill that can be acquired. Major business investments offer the potential for your business to generate higher profits, but also tend to carry a big price tag, and a significant long-term financial commitment. Capital budgeting addresses this. It describes a range of useful methods for considering the potential purchase, and asking, “is it worth it?”
Tied closely to this is the concept of forecasting. In other words, predicting how your business is going to perform, the expenses you are likely to incur, and the level of sales you can expect over a given period, based on evidence — rather than guesswork.
Taken together, forecasting can help you decide whether it’s possible to take on the financial commitment linked to a big purchase, while capital budgeting helps you decide whether the decision to invest is the right one for your business. Here, we’ll illustrate how small businesses can put capital budgeting and forecasting to work.
The value of forecasting
Even if you are not planning on any big purchases or investments at present, forecasting is still a crucial element of business management, especially when it comes to drawing up a business plan and maintaining a budget. It involves considering each category of expense and income applicable to your business over any given timeframe and then predicting the relevant amount likely to be incurred or earned.
When you put forecasting to use in preparing your business budget, it should help you come up with a predicted net income figure for the relevant period and, from this, you get a realistic picture of the amount of cash that’s going to be available for reinvestment in the business. Especially in retail, forecasting can help you deliver a better service to customers, too. By predicting sales revenue (i.e. product demand), you can see how much stock you need to order — so customers are not faced with bare shelves or a long wait for delivery.
Realistic forecasting for small businesses
It’s important to approach your forecasting exercise methodically, so nothing is missed.
Starting with expenses, fixed costs are the easiest expenses to forecast. This is because they remain at the same amount each month or year, irrespective of your business income level.
- Loan repayments
- Permanent staff costs
- Admin costs
Variable costs are those associated with producing goods or services (e.g. fresh supplies for a catering business, or fuel for a delivery service). So, to forecast these, you’ll firstly need to predict your level of income — i.e. your likely sales revenue. There is no single, set method for doing this, but it’s important to be realistic and, if the picture looks uncertain, to edge towards a conservative estimate. It’s far better to find that you have a surplus at the end of a forecast period than it is to deal with cashflow problems caused by an overly-optimistic prediction.
To give a couple of examples:
- A self-employed consultant may find that income levels fluctuate considerably from month to month. A reasonable annual revenue forecast for the coming year could be obtained by calculating the average monthly earnings over the previous year and multiplying this by twelve.
- A bar owner might only have been trading for six months, but over that period has seen revenue rise steeply month-on-month as word spreads about the business. At some point, that level of growth might be expected to stabilise as the number of new customers reaches saturation point. So here, it might be appropriate to factor in a growth level of two percent per month for the year.
Putting capital budgeting to work
Businesses invest in ‘big ticket’ items, such as new equipment and machinery, because of the potential of these items to generate bigger profits. Capital budgeting methods enable you to measure this potential and to factor it into your forecasting and budgeting. It can also help you choose between different purchasing options.
Net Present Value
One simple method of capital budgeting involves looking at the Net Present Value (NPV) of a proposed purchase. For this, you need to consider how much money will flow into the business as a result of the investment. For instance, if you are considering buying a van in order to offer a delivery service, you would need to forecast the extra revenue this is likely to generate.
Consider the cash flow
You should also consider the cash flow out of the business in order to make and maintain the investment. It may be that paying for the van requires a loan spread out over three years. However, you expect the vehicle to have a useful life of five years. You work out the NPV by calculating the difference between all inflows and outflows associated with the investment over the lifetime of the investment.
You might also find it useful to work out the ‘Payback Period’ for a particular investment. For example, the length of time it will take for you to recover the entire cost of it. Let’s say a piece of production machinery will cost you £30,000 to purchase. This machinery enables you to expand your product range. You forecast that it will result in profits from extra product sales of £15,000 each year. The payback period is, therefore, two years. But if this piece of equipment has a useful lifespan of just two to three years, you will barely break even from the investment. If, however, it has a useful lifespan of ten years, it represents a potentially much more profitable purchasing decision.
Applying the basics of forecasting and capital budgeting are just two of the ways to help you make sound, evidence-based business decisions. For further guidance on all aspects of managing your business, head over to our help centre.