Founder’s Corner Budgeting

Budgeting is the most wonderful time of the year.

Halloween, Thanksgiving, and Christmas are great holidays, but its Q4 budget making time that really gets me giddy…

No, I’m not that lame.  My colleagues and kids might disagree, but how can anything compete with glutinous turkey indulgence and piss poor football games (when was the last good turkey day game…)?

Every year around this time, companies go in to budgeting mode.  Close the books on Q3 and you can estimate out Q4 with a reasonable degree of certainty giving you a fairly good idea how the year has gone/will finish up.

In the words of my favorite football coach, Bill Belichick, “We’re on to next year.”

I’ve gone through the budgeting exercise every year where time is spent analyzing expenses to estimate future needs.  Usually a valuable exercise. Can be painful, but usually creates solid outcomes, especially with technology and personnel needs. It sets the tone for management of whether it is a spend year or a tighten your belts kind of year.

What isn’t easy is forecasting anomalies and revenue.  These are the two areas that are always, ALWAYS wrong!

Legal is the most common anomaly to plan around.  Sure, you don’t want legal bills and of course you’ll be wanting to make an opportunistic, strategic acquisition.  And why would anyone ever want to sue you?

Do you sand bag the legal line item up in the event something could happen?  Legal is a budget buster category or it’s a way to say the company is spending well below forecasted expenditures.  I can’t tell you how many times I’ve presented financials to Boards saying “we’re way under budget on our expenses” when it is because of all the legal padding, not because we’ve been so astute at our expense management.

Income statements take anomalies in to account by calling them “Other Expenses” or “Extraordinary Events.”  I remember the anecdote about earthquakes.  Are earthquakes common?  Sure – but only in certain areas.  I don’t plan for an earthquake in Colorado, but I certainly would in California.

You have to examine a P&L (and balance sheet and cash flow statement) top to bottom to see the whole picture.  I’ve had CEOs focus only on ordinary income (EBITDA) to tell if the business is operating properly.  In my opinion, that is extremely shortsighted.  Interest, taxes, depreciation and amortization tell a lot about companies.  For example, spikes in depreciation tells the users of the financial that capital investments are being made and tax strategizing shouldn’t be overlooked by companies.

What’s the first thing I do when I’m looking at financials? Scroll to the end of the document and look at the net income, AKA the bottom line.  That’s the scorecard folks. The end-all be-all.

So you’ve done your expense analysis.  You’ve factored in padding for anomalies.  But wait.

Oh no. 

Your net income number isn’t what you want it to be.  Whatever will you do?  Here’s where the wheels fall off in creating a budget.

Revenue is (arguably) the biggest error that is made in forecasts.  Salespeople go in to the year wanting the expectations to be low.  They want to have achievable goals that once they exceed, they will get their bonus commissions.  Management wants to sell the Board and other stakeholders that the future is always brighter than the present (hopefully it is, but sometimes it isn’t), so they want proformas to show the upcoming year will be a banner year with a healthy net income.

I’m always asked for conservative and stretch forecasts.  The hope is that what actually happens falls somewhere in between, and hopefully closer to the stretch goals.

I’m not saying projected revenue doesn’t have its place. Goals are important.  What I am saying is that spending a ton of time trying to compute future revenue, or trying to validate how someone came up with revenue, is just a waste of time since you know that as soon as you put it on paper, it is wrong.  Have a rough methodology in place.  You know your contracts, you know your corporate assets that are being put to work.  Run a couple of scenarios and call it good.  You’ll glean a lot more information about a company by reviewing what they are thinking on the expense side than the revenue side.