What Are Capital Budgets and How Can They Affect Your Business?

My bank won’t finance the equipment I need to grow my business without reviewing my financial statement projections and “Capital Budget.” Where do I get one of those?
Wouldn’t it be nice if we could just run down the block and purchase a capital budget that would satisfy the bank’s desire for additional information? Unfortunately, capital budgets are developed to fit the individual needs of companies and are not available to buy off the shelf.

Capital budgets and financial statement projections are similar in that they are forward-looking documents.

Capital budgets typically pertain to equipment or capital projects and are used to determine their viability. According to AccountingCoach.com, capital budgeting is defined as “a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures.”

The three most popular methodologies used to evaluate equipment purchases and projects are:
Payback – calculates how quickly an investment is paid back from the net profits the investment generates. The advantage to this method is that it is easy to calculate and understand. The disadvantage is it doesn’t consider the timing of varying revenues and expenses.

NPV (or Net Present Value) calculates the discounted value of all revenues and expenses to a current period and netted against each other to determine a net positive or negative value. The advantage of this method is that it considers the timing and amount of money spent and received. The disadvantage is the need to determine the appropriate discount rate of a project or differences in risk of varying projects.

IRR (Internal Rate of Return) calculates the overall return that equates all future net cash inflows to investment expenditures. The advantage is this method calculates one yield for overall yields (on conventional transactions). A disadvantage is that other than yield, no information regarding timing or magnitude of investment is available.

A key determinate to successful capital budgeting is the ability to collect the necessary information that is both accurate and inclusive of all factors to be considered. The amount and timing of various revenues, expenses, cash inflows, cash outflows, depreciation, and taxes are some important factors to be considered in a capital budget.

A credible capital budget will ensure that you will get financing for your project under the most favorable terms and conditions for your project.