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Developing a Cash Budget and Internal Rate of Return for Capital Budgets
Budgets are short-term plans for how businesses will operate, how money will be spent, how income and revenue will be received. A good budget enables 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. Here is a close look at both.
A cash budget is similar to a household budget. The main value of a cash budget 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
The first two categories are, as mentioned, relatively easy to determine. The third, estimated sales and expenses requires a closer look, since those items make up the bulk of a cash budget.
Estimated Income and Expenses
Estimating income (sales) is the foundation of a cash budget; once you have that number, many expenses naturally follow. The problem is 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 should be a little more 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 might look like (in simple terms):
Keep in mind the above is a high-level view of what a budget might look like. Each line item could contain a number of sub-categories for more detailed budgeting.
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.
Here is a closer 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. Discounting the effect of interest or the time value of money to keep things simple. For example, 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.