The annual budget is the simplest means of directing and controlling a small business. It is the one planning tool essential for effective operation. The annual budget links the business plan to business reality because it not only projects the business's direction, but is a means of tracing the flow of money into, through and out of the business and helps the owner determine how to use scarce resources. By comparing actual results with projections, the owner is able to evaluate the effectiveness of various business activities. Not having and not using a budget is a common reason for cash flow problems and subsequent business failures.
Budget is used as a flexible guide.
The budget does not represent business reality - it is merely a map describing where the business is going. A major mistake that often occurs with the budgeting process is thinking that money allocated to a certain expenditure actually exists in the bank. Effective business owners constantly check the budget against operational reality and make changes in the budget as needed. Flexible budgeting in response to actual business performance is the mark of a shrewd businessperson. Too rigid adherence to the budget often leads to poor profit performance and even bankruptcy.