In our opinion, the vast majority of small businesses don't need to prepare budgets or forecasts.

Most business owners are entrepreneurial by nature and do just fine without them. However, if you're lucky enough to have a rapidly growing business, or if you’re planning to apply for a bank loan or seek outside capital in the near future, then you might be at the point where you need to start building a formal budgeting process.

If you’ve never prepared a budget before, the idea can be daunting. Where do I start? What information do I need? How can I come up with accurate projections?

The good news is that budgeting and forecasting isn’t as hard as most people think. In fact, the overall process can be boiled down to three general steps:

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 2-3 years and lay them out on your kitchen table. Unless you’re launching a new business from scratch (in which case there’s no prior 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: come up with a few reasonable assumptions

Next, take a step back and make a few educated guesses about what's going to happen with your business in the future. Don’t worry about crunching any numbers yet, just start by asking yourself some basic questions. Is the market for your products increasing or decreasing? What do you think your sales growth will be next year? Will you be facing any big expenses or investments — like new employees or increased advertising/marketing expenses or fixed asset purchases?

Trust your instincts and try not to overanalyze. Most business owners have a strong sense of intuition about these things.

Step 3: Forecast your expected revenues and expenses

This step takes a little time, but it’s not as difficult as it sounds. The basic idea is to take your historical financial data in one hand and your forward-looking assumptions in the other, then use them to forecast your expected revenue and expenses for the next twelve months. The result is a projected income statement (or P&L), and this will serve as your operating budget for the coming year.

One last idea. When it comes to sales forecasts, it's often useful to look at two different scenarios: a conservative one and an aggressive one. Why? Because nobody knows for sure what’s going to happen with sales, and most business owners fluctuate between a safe projection (what they know they can get) and an optimistic one (what they hope they can get if everything goes well). The truth often ends up somewhere in between, so it can be helpful to look at both possibilities.