Many of the business owners we work with have admitted to spending days, if not weeks, pulling budgets together for a specific point in time--to present at an investor meeting, to kick off a new product launch, to start a new year--but most never take the time to keep the budget updated afterward. Others have never built a budget at all. And, while most understand the importance of financial modeling and budgeting, they use the two terms interchangeably. So...
What is the difference between a financial model and a budget?
Simply, a financial model is a business tool for compiling and analyzing financial data. It can be backward-looking or forward-looking and acts like a calculator to generate an output. The output of the financial model can be used for budgeting, as well as other things such as scenario analysis, inventory planning, pricing decisions, determining your optimal product mix, investor due diligence, and myriad additional business cases.
A budget forecast is essentially a financial model built specifically to create a budget. It uses a set of assumptions, as well as historical data (if applicable) to forecast a future state of your business.
A budget is the output of your budget forecast financial model and represents your target expenses and revenues for a specific time period. You will use the budget to compare to your company’s actual Profit & Loss (P&L), and use this comparison as a learning to better understand your business’ financial levers and more accurately budget in the future.
To simplify, here we will stick with the terms financial model and budget.
The financial modeling and budgeting process
We won’t get into building a model here, because we’ve already covered that in the aforementioned blog post on How to Build a Basic Financial Model. What we will talk about is how the model, budget, and your accounting platform work together to provide insight into your business. Here are the steps we (meaning the financial analysts in Paro’s network) typically take when we work with clients to develop and review a model and the budget output of that model.1. Build the model in Excel
We build the financial model in Excel, making sure not to hardcode any numbers. We work closely with the business owner to understand how you’re thinking about your business for the coming year, what assumptions you’re making about your fixed and variable costs, as well as how much growth you think you will experience. We also look at your historical data to see your expenses and revenues from previous years. If you don’t have historical data, we rely on the assumptions, but make sure to understand where they came from.
Something to note when building the model is that if you are already up and running with accounting software, the expense and income categories in your model should match the already-established categories in your platform. If they don’t match, it will be impossible to see the budget and actuals side-by-side in the platform.
Once you are comfortable with the inputted numbers and the outputs shown, this Excel model essentially becomes your budget (once you’ve loaded it into QuickBooks or whatever platform you use). If you don’t use an accounting platform, then we need to talk; it’s a much more difficult and manual process to review your budget to your actuals in Excel.2. Input the Excel model data into QuickBooks.
We input the expenses and income--by category, for each month--from the model into QuickBooks. Currently, this is a manual entry process. The model now becomes a static budget that you will use to compare what you predicted would happen with your business month-over-month to what actually happens with your business.3. Evaluate the budget vs. the actuals in QuickBooks
Every quarter, we vet the budget against what actually happened: QuickBooks shows the budgeted numbers next to the actuals and calculates how much over or under budget we were (so helpful, right?) We ask questions like:
- Are our expenses in line with what we forecasted, or are they substantially lower or higher. If the latter, why? Did cost of goods sold for a certain ingredient increase? Did rent go up 5% instead of 2%?
- Are we bringing in as much money as we expected? Did we underestimate how many items we would sell in a month or did we assume each client would spend more on our services than they actually did? Did we lose or gain a big client?
If we find that the budget and actuals don’t match, we need to go back and reevaluate our assumptions (back in Excel). For example, if we budgeted our cost of goods sold to be $100, but the actual cost ended up closer to $200, we need to know why. And, we don’t want to keep comparing what’s actually happening to a budget that doesn’t account for the new information we’ve received. So, we go back to Excel and adjust the assumptions.5. Update the budget in QuickBooks
Once the model reflects the updated assumptions, we input the new data back into QuickBooks. You now have an updated budget to vet your actuals against.6. Rinse and repeat every quarter, or whatever cadence you decide
How often should I update my budget?
How often you update your budget, is up to you. In the steps above, we chose to review quarterly. But, if you have the time to sit down every month and adjust your budget to your actual performance, do it. We suggest picking a cadence that works for you and sticking with it, whether that’s monthly, quarterly, or semi-annually. Just don’t set it and forget it.
If you do nothing else, make sure to spend some quality time comparing your budget to your actual spend and revenues at the end of the year. While the information won’t be as immediately actionable, you’ll at least have uncovered important learnings to include in next year’s budget.
Testing different scenarios with your model
Your model can be used throughout the year to test out various scenarios and how they affect your P&L. Here is one simple example of how you can use your model to understand various possible outcomes:
Say you make a health bar with almonds as the primary ingredient. You originally budgeted your cost of almonds to be $2.50 per pound. Then a drought hit California--which grows 80% of the world’s almonds--and the cost of almonds skyrocketed to $4.00 per pound. This is where your financial model comes into play. Assuming you have built your model correctly, you should be able to go to your Assumptions tab and change the price of almonds from $2.50 to $4.00. Your entire P&L will update to show you how this significant cost increase will affect your bottom line for the year.
And then you can start testing various options:
- What happens to the bottom line if you increase your price per unit?
- But if you increase the price too much, some customers may not buy. How many? You can test by decreasing your number of units sold.
- What happens if you substitute another, less expensive nut? You may also consider decreasing your number of units sold if your customers prefer almonds.
Obviously there are myriad of testable situations. Using your model, you can compare several to choose what makes the most sense for your business.
One final reminder: never hardcode numbers in Excel!
This may be the most important takeaway from this article: when creating, updating, and manipulating your model, do not hardcode your calculations (please, we beg you!). You may remember that the 12 in that calculation refers to 12 months and that the 4 refers to 4 quarters in the year, but... you may not, and the finance expert you’ve hired to help definitely won’t. If there’s one thing we’ve learned from working with multiple clients in dozens of industries, it’s that we always think our memories are better than they actually are.
This article originally appeared on Paro's blog.