Let’s be honest: Most small businesses don’t need to worry about budgeting and forecasting. Why spend hours/days/weeks working on an annual budget when the numbers keep changing and the budget will be out of date by the end of Q1? You’re better of looking at your monthly financial reporting and getting a few good KPIs in place.

However, if you have a rapidly growing business or you plan to apply for a bank loan or revolving credit line in the near future, then it might be time to build a formal budgeting system. Here’s a quick summary of what that process looks like:

Step 1: Look at your prior financial results.

The starting point for any budget or forecast is to gather your financial statements for the past 1-3 years and lay them out on your kitchen table. Unless you’re starting a new business from scratch (in which case there’s no historical data to look at), this will serve as your foundation and provide the baseline for what’s going to happen next year. As the old saying goes: “Past results are the best predictor of future performance.”

Step 2: Write down some reasonable assumptions.

Next, take a step back and make a few educated guesses about what you think is going to happen with your business in the coming year. Don’t worry about crunching any numbers yet, just ask yourself some basic questions. What’s happening in your industry? Is demand for your products/services increasing or decreasing? What happened with your revenue last year, and what do you think is going to happen this year? Are you expecting any significant increases in your COGS or operating expenses? Try not to overanalyze, most business owners have a good sense of intuition about these things.

Step 3: Forecast your expected revenues and expenses

This step takes some time and work but it’s not as difficult as it sounds. The basic idea is to take your prior financial results in one hand and your reasonable assumptions in the other, then use them to build a projected P&L for the next twelve months. And voilá: This will serve as your sales forecast and operating budget for the coming year.