As owner, do you like to have a regular draw from your business? And a draw that doesn't change wildly from year to year? If so, you need to do capital budgeting!
Capital Budgeting Defined
First let’s define the meaning of “capital budgeting” and “capital investment.” A capital investment is the purchase of a long-lived asset that is expected to last more than one year, and typically multiple years.
Capital budgeting is the process of planning which capital assets will be purchased, when, at what cost, and from which funding source.
Trucks, tools and equipment, buildings, computers and IT equipment are all common examples of capital investments made by small businesses.
Ready, Set, Plan!
So, as we charge further into the new year, the question I ask is: have you set a plan for how much you will spend on capital assets for the year ahead?
And have you considered where you’ll get the money to purchase these assets and what impact their purchase will have on other considerations, like cash for your draw as owner?
While I don’t mean to be cynical, the reality is that I’ve found very few small businesses do capital budgeting at all, let alone well. Most ride the roller coaster of making these big purchases when they simply cannot hold out any longer, on a whim, or at year-end to reduce their taxes - generally with no advance plan or available resources allocated or lined up for purchase.
Since this approach can be so disruptive to a business, I want to propose a better way for you and your business. It doesn’t necessarily take a lot of time (especially after the first time) or sophistication… but the following systematic approach will over time save you, as owner, a lot of headaches, and smooth out and improve the efficiency of your business!
What Do You Need?
Step one of the process is to simply identify needs. Make a list of your fleet of trucks and their age and condition. Then, order that list by which ones need to be replaced most pressingly and when, and list things out in yearly columns going forward by 3-5 years or so. Label this worksheet or list as your Capital Budget.
Do the same thing for all other assets your business needs to operate. Tools and equipment. Office furniture. Computers and IT equipment. In the case of small items like tools, you don’t need to list each individually. Instead, have an aggregate line in your budget for an average amount your business spends on those items per year.
How Much Will It Cost?
Next, after listing each capital asset by name or grouping, obtain or accurately estimate the cost of replacement for that asset. For each of your trucks, that figure may be $30K, $40K or $50K. For each computer it may be $600. Small Tools purchases per year might be $500, $1K or $5K.
Borrow or Buy Outright?
After you know what you need in capital assets, when you’ll need it, and how much it will cost, the obvious next step is to make a plan for how your business will be able to pay for it.
In many cases, larger capital expenses are paid for with borrowed money. Loans from the bank or credit union. Or from investors. In other cases, businesses pay for their capital assets using cash flow generated from business profits.
My own bias is in favor of using cash flow generated from profits, but whatever the case… it is essential that you know where the money is going to come from to fund all capital asset purchases.
Consider which money source is best for funding your business’ capital purchases, and plan ahead to have money in place when your business makes each capital investment.
Trade-offs are Necessary
Whenever I go through this process for the first time with a business owner, it almost always leads to other considerations and implications. Owners often say or think things like: If we buy this truck this year, then I won’t be able to… If we don’t buy any new trucks and only do a computer or two this year, then we’ll be able to…
And that is why multi-year, advance capital budgeting is so helpful and important. So much in life and running a business is about trade-offs. Capital budgeting helps owners see and plan in advance those trade-offs so that they don’t get caught off guard by business-disrupting capital investment requirements.
Avoiding Binge-Starve Seesaw
The most disruptive pattern I have witnessed is the binge-starve seesaw that occurs when a business has no capital budget or cash flow management plan. In such cases, almost always the squeakiest wheel gets oiled – often under emergency circumstances – and it leads to huge seesaws in the way a business’ cash is utilized.
Last year, the owner got caught up on personal bills and taxes, and significant draws were taken. Meanwhile, no trucks were purchased or replaced. This year, owner got almost nothing to live off of, while multiple trucks were replaced (perhaps when major operations-disrupting breakdowns occur). Next year, all the office computers will get replaced and a new truck added to the fleet, and the owner will get a draw but not enough to keep up with taxes and bills.
If you don’t want your owner draws to fluctuate like this, capital budgeting will help you smooth things out so you don’t experience the nauseating ups and downs of the seesaw.
Integrated Planning Will Make You Happy, Happy, Happy!
Effective personal budgeting, hidden cost planning, operations budgeting, growth pace planning, and capital budgeting are all key ingredients to making your life happier and smoother as owner and manager of your business.
In this post and the links above, I’ve given you lots of guidance on how to do each step well. And if you’d like some assistance from us in doing so, I encourage you to contact us here.
Long live small business! Long live small business owners!
Jim Smith, CFP, Founder, PERFORMIDABLE, LLC