Budgeting vs. Forecasting: What's the difference, How are they used, and why are they important?
Katarina Abri
Vice President of Finance
November 8, 2021
How do you turn a good idea into a great business? While success depends on many factors, ultimately it comes down to a company’s financial health. Budgeting and forecasting are two critical tools for guiding your business. But what’s the difference between the two, how are they used, and why are they important?
These are common questions for many venture-stage CEOs and founders so let’s break it down.
What is a budget?
A budget represents a company’s financial plan for the year. It’s a roadmap of what leadership aims to accomplish that details P&L, balance sheet, and cash flow projections. A well-planned budget helps leadership operate within their means, adjust to unforeseen challenges, and increase profitability and revenue. When building a budget, you will want to analyze past trends and market behavior while taking into account anticipated changes to business and company goals. The budgeting process typically occurs at the end of Q4 or very early in Q1 and for equity-backed startups, budgets typically get approved by their BOD (board of directors).
What is a forecast?
The Corporate Finance Institute (CFI) defines forecasting as “Predicting what will happen in the future by taking into consideration the events from the past and present.” For venture-stage startups, forecasting and reforecasting is the process of evaluating your budget assumptions and making necessary changes based on actual internal performance year-to-date (YTD) and external factors that were not previously accounted for. CFI explains, “It is a planning tool that enables businesses to chart their next moves and create budgets that will hopefully cover whatever uncertainties may occur.”
The timing and frequency of forecasting and reforecasting will vary depending on several factors, including how your business is funded, whether there are external reporting requirements from 3rd parties (board/investors, banks, or other lenders) and if there are significant shifts in the business climate.
How to develop a budget
Developing an accurate budget is the first step in effectively managing your finances. When working with my clients, we consider the following factors:
Actuals from the prior year(s) - Past performance is a strong indicator of future performance. The numbers, grounded in reality, are an excellent stepping-off point. Do you have plans to change your business model? If not, your prior year's financial results and KPIs (key performance indicators) will help you establish a realistic growth goal to budget for. Start by looking at your year-over-year (YOY) revenue growth rate and seasonality from prior periods, and depending on your long-term goals (e.g. exit or acquisition), determine your realistic yet healthy growth rate for the upcoming period.
Market trends - Business and industry trends are important indicators and impact growth expectations and goals, especially for e-commerce and the health and beauty industries. Seasonality can significantly affect sales volume around Valentine’s Day, Mothers Day, and the Q4 holidays. Having a deep understanding of the industry you're in or working with a financial partner who does, gives you a major advantage when it comes to identifying and predicting trends and building them into the budget.
Changes to the business operations - It’s important to assess anticipated changes to the business operation. For example, if a company is thinking about switching suppliers with more favorable terms, this may positively affect your margin as well as cash runway.
Changes to the business model - A founder may learn that despite having a great business idea, the business model as it was initially set up needs to change which inevitably affects the financial projections. Once again, those factors could be internal or external. Many companies were forced to shift or altogether alter their business model in 2020 due to the global pandemic that wreaked havoc on businesses and supply chains worldwide.
Cash runway - Simple as it may be, cash is the lifeblood of any functioning business and drives a significant part of planning. The amount of liquid cash available determines how much and what type of expenditures a company can afford. For example, if a company has just raised Series A or Series B funding and is focused on significant growth in the current period, they most likely want to invest that money into people, technology, and marketing to increase revenue by 2x or 3x. That's going to inform the budgeting process differently than if the company’s cash runway is minimal: the company needs to be more conservative and we would work to create a budget that extends the cash runway as much as possible while showing some growth with minimal investment.
Long-term goals - Understanding a company’s mid-term and long-term goals is critical in the budgeting process. Creating a budget for a company aiming for continued steady growth will be different from a business whose goal is to exit in two years and needs to reach competitive market revenue and EBITDA (earnings before interest, tax, depreciation, and amortization) thresholds.
When to reforecast
Even the best-laid plans don’t always go as expected. Many times founders (or their boards) set aggressive revenue goals in the budget, and as the year progresses, certain factors come into play that requires a more conservative reforecast.
The frequency with which a company reforecasts is driven by internal need and what is an add-on value and a cost of a reforecasting. The primary goal is to understand and adjust to the perpetual external and internal changes to the market.
As a general rule of thumb, before the pandemic, I would re-forecast at least twice a year. Given the turbulence and uncertainty of the past year, I recommend my clients re-forecast quarterly, at a minimum. Some clients reforecast monthly to truly understand their cash runway. These companies are typically self-financed, and it helps them determine whether they need to fundraise or bring in debt capital.
By taking the time to reforecast, company leadership can analyze how it stacks up against projections, evaluate how they are tracking against their plans, stay abreast of their cash position, and make adjustments based upon market trends and internal realities.
Why are they important?
Company leadership, boards, and lenders will want to know how company performance is shaping up against the budget. This is especially true when approaching a capital fundraise. Martin Zwilling, Founder, and CEO at Startup Professionals, Inc. points out: “External investors will demand a financial forecast, but it’s equally valuable to you, even if bootstrapping. How else will you be able to convince yourself and your team that your business is viable? You need these projections to set internal goals and milestones, and to measure your progress toward reasonable success objectives.”
- Proactively respond to unpredictable factors – Taking the time to review the company’s actuals against the budget allows leadership to be proactive, respond to unpredictable factors, and create a more realistic reforecast. For example, a company may lose a key employee, forcing them to reassess how the loss impacts the performance of the business. External factors can affect performance as well. In Q2 of 2021, Apple changed its privacy rules. The change had a ripple effect, significantly increasing the price of paid advertising across Google, Facebook, Instagram, TikTok, etc. In turn, that greatly impacted their CAC (customer acquisition cost).
- Better understand your current needs – The reforecasting process also helps your BOD and lenders understand your current needs, react proactively, and advise on the overall business strategy. They will help answer questions like how much additional capital may be needed, whether the current facility to finance inventory needs to be increased, etc. They will also want to know how leadership intends to react to internal and external factors and what opportunities to make up for differences and reach the initially projected budget.
Budgeting and reforecasting are two essential tools business leaders use to track their financial performance and make strategic adjustments to remain on course for profitability in the long run. It is beneficial to have a CFO with industry knowledge, experience building budget models, and a steady eye when evaluating YTD performance when forecasting.
If you are a venture-stage startup looking to professionalize your finances, we’re here to help.
Let’s start a conversation today.
