Finance From A-Z: Capital Budgeting

Term: Capital Budgeting

Definition:
The process of determining the amount of money to set aside for the purchase of fixed assets and long-term projects – this includes determining which are worthwhile by comparing the investments choices using some type of project evaluation method like discounted cash flows, Return On Investment (ROI), payback period and  internal rates of return (IRR).

What Does This Mean To Me:
Often capital budgeting is thought to be a large business activity vs. a small business one. That is because large businesses can have multiple projects that need to be evaluated and determined which are the best investments. However, it is just as important, if not more important, for small businesses to plan how each excess dollar is spent.

The small business challenge is identifying enough viable projects to choose from so extensive analysis is justifiable.  Contrary to what some business consultants recommend, I encourage small business owners to do more analysis – not less. My logic is that the smaller you are the less margin for error you have and there is less profit to cover up your mistakes.

Capital Budgeting Process:

Here is one exercise I use for capital budgeting. I work with an owner or management team and lead them through a six step process.

  1. First, we prepare a Cash Flow Budget for the up coming year. It includes forecasting revenue and operating expenses. This  includes interest and principle payments on loans.
  2. Next, we determine if there are any cash flow short falls. If so, identify the recovery source.
  3. Now, w e identify potential Fixed Asset purchases or Projects that cost  greater than $500. These are items or projects that will help grow the business in some way and have been deemed “strategic”. These projects are ordered by spending amounts and then weighted by qualitative factors like: impact on business objectives or customer relation impact. The weighting is usually on a scale of 1 – 5.
  4. Then we look at the top 20% of the items or up to 80% of projected excess funds and these are the projects we evaluate.
  5. Next, we conduct the evaluation. The evaluation methods vary. It could be discounted cash flows, ROI or IRR. However, I always encourage that some type of time value of money methodology is used.
  6. Finally, We then select our capital spending items. Depending on actual available cash and the current business environment, we execute on the capital budget.

This process assumes that there is a financial performance review process in place and the company has documented goals – but that’s a whole other discussion.

Click on this link for a cash flow budget spreadsheet to get you started. But remember the tool is only as good as the plan to use it and the quality of the execution.

Manch Kersee
JR Dexter, Inc. – “Business Decision Support”