Financial Budgeting: Principles and Model Development

Key Principles of Financial Budgeting

Entity Principle

Consider the company as a functional entity.

Leadership Principle

The Financial Planning Manager develops and coordinates the budget.

Authority Principle

The Finance Manager supervises and presents the budget to the Board of Directors (Partners).

Participation Principle

Involve all key participants in the budget's preparation.

Commitment Principle

All managers undertake to follow the budget, notifying any deviation in a timely manner.

Goal Principle

The budget is based on the strategic planning objectives.

Accounting Principle

A budget system should mirror the current accounting system.

Measurement Principle

All estimates must be in currency units.

Predictability Principle

The predictions generated must be as close as possible to reality.

Flexibility Principle

The budget should adapt to the operational reality while accepting some exceptions.

Truthfulness Principle

The budget truthfully validates the profits instead of using "happy numbers".

Monitoring Principle

The budget serves as a weekly monitoring tool for current financial results.

Delivery Principle

The budget is developed in September and delivered in October.

Developing a Financial Budgeting Math Model

Quantitative Assumptions

• Quantitative assumptions identify the expected parameter for each item on the balance sheet or income statement.
• Parameters are determined using figures from past periods (last real month). If these are not available, they are established using experience criteria, ensuring they are viable and not "happy numbers".

Ink Color Code

• Some parameters remain constant, while others will be changed to adjust the budget to our needs.
• Constant parameters remain in black ink.
• Changing parameters remain in blue ink.

Assumption's Scorecard

Budget parameters are prepared in the form of a scorecard. Once the entire model is completed, changes can be made to blue parameters to fine-tune the results to more feasible conditions.

Mathematical Model Structure

The mathematical model structure includes:

1. One-time event transactions, e.g., owner investment.
2. Recurring event transactions, e.g., sales are recurring monthly.
3. A trial ledger that includes all possible transactions.
4. A trial balance with the same structure as the trial ledger.
5. Financial statements.

Validating and Refining the Model

When the numbers in the mathematical model are similar (not necessarily equal) to the actual figures, then you can consider it finished.

• If you think that some adjustments can be made to improve it, go ahead.

Simple vs. Complex Model

• You should never lose sight of building a simple, not complex model.
• When the model results differ from the actual figures, in a complex model it can take many hours of work to find the model's failure.

Calculating Annual Income and Profit

• The annual income statement is calculated by adding each line of the income statements for January through December.
• For the balance sheet, the cash flow, and the equity statement, the financial statements at the end of the year are the same as those for December. Remember that they do not add up to periods; they are a snapshot of the moment.
• After validating that the mathematical model works correctly, the 12 months are added together to determine the budgeted annual profit.
• We must analyze if the calculated profit justifies the effort required by the business.
• It's time to play with the parameters to see the impact of raising the price or lowering costs if you are looking to improve profits.
• In my experience, the best option to increase profits is by increasing the volume or the sales price, if the market allows it.
• Increasing profits through cost reduction has a very low impact.
• It's time to make sure our parameters are not "happy numbers".