A capital budget is developed when a business wishes to invest resources into a project that is expected to produce returns over a multi-year period. It's also referred to as an investment appraisal. The analysis behind planning a capital budget differs significantly from planning an expense budget. Since the capital budget is a representation of the business's strategic plan, careful financial analysis must be undertaken in advance to improve the likelihood of success.
The Creation Process
Because the capital budget is a long range planning tool that incorporates the business's strategic vision, it's wise to consider a multitude of investment opportunities before committing resources to just one plan. Performing an analysis of each plan's pros and cons is a wise start. The plan with the greatest anticipated return on investment that best aligns with the business's goals should be selected; the financial planning analysis is what's used to determine each plan's likelihood of success.
Capital Budgets Vs. Operating Budgets
Because capital budgets often last for more than a year, it may be easier to break the budget up into smaller chunks to better match expense budget time periods. For example, aligning anticipated annual revenue with capital expenditures can result in better financial analysis. Ideally, an increase in revenue can be tied to the capital project -- expenses may increase, as well. If a financial planning analysis reveals that the capital budget isn't performing as planned, an adjustment should be made either to the capital budget process or to the operating budget. Capital budgets may include purchases for real estate, equipment or other assets. Operating budgets include revenue, salaries, office supplies, depreciation and travel expenses.
Financial Planning Analysis
Building a capital budget can't take place in a vacuum, however; if the business's cash flow and revenues indicate that the business can't afford a project, expectations have to be dialed back. Financial planning analysis provides a dose of reality -- and advice -- to those who are in charge of the capital budget, because a financial planning analysis will also examine the potential affects of the capital budget on the expense budget. Simply put, the financial planning analysis must integrate the anticipated results from the capital project into the business's strategic financial plan.
Planning for Debt
If the capital project requires the business to accumulate debt, the risk of harm to the business increases. As a result, the financial planner must calculate the level of risk that the business is assuming by putting future revenue resources into a capital project. However, a well-calculated, lucrative risk should induce growth, or at the very least, a furthering of the business's strategic vision. The best capital project results are caused by careful financial planning and analysis.
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