Data is like garbage. You’d better know what you are going to do with it before you collect it.
From the Steering Bird team, online advisers in business direction, finance and strategy, we are going to talk about some issues related to projects. We start by giving you some tips so that you can make a good financial model for project evaluation.
What is a project?
Begin at the beginning and go on till you come to the end; then stop.
According to the PMI (Project Management Institute) and as indicated by the PMBOK, a project is “a temporary endeavor undertaken to create a unique project service or result”. Projects are carried out to meet objectives, through the production of deliverables, which can be tangible or intangible.
Projects are temporary, have a defined beginning and end. Additionally, projects must be closed after the work for which they were authorized is completed. For example, an industrial plant construction project ends when the plant is fully built – and delivered. Then, the operation of the plant begins, which is not part of the project.
The project format is very useful to evaluate whether a business alternative is viable or not. You can use it for matters as different as:
- Evaluate a new business
- Analyze a new product or service
- Investments in fixed assets (new or expansions)
- Compare alternatives for asset replacement
A project must have a plan, which indicates if the commercial, legal, financial, environmental conditions exist, etc. that make it viable. In our Business Plan article, we talk about the different plans you should make before starting to evaluate your project.
How to make a good financial model for project evaluation?
Plans are only good intentions unless they immediately degenerate into hard work.
On this time, we will tell you about the financial project, in other words, the financial model for evaluating it. We will focus on five critical factors that you should be clear about before thinking about preparing your project flow.
1. Project Term
You may delay, but time will not…
You already know that every project must end. For the financial project this is fundamental. Setting the project term and timeline is not a matter to be taken at random. In this regard, we can tell you that:
- In projects that have to have a specific deliverable, such as a new product or service, the commercial launch date will define the project term.
- About asset replacement projects, the term of the useful life will define the term of the construction project or purchase of the new asset. If replacement options with different useful lives are compared, the project term will be the least common multiple of the useful lives of both alternatives. For example, if the replacement alternatives are A, with 5 years of useful life and B, with 4 years, the project will be evaluated for a term of 20 years.
- It is not realistic to do an evaluation in a very short term, such as 1 year, because you will not be able to gather all the necessary information. Nor is it realistic to do it in a very long term, such as 100 years, since the estimates will not be representative and mathematically the contribution of values in very long terms is irrelevant.
You should look for a term that helps to understand the project as a whole and that, in addition, allows you to evaluate the improvements that the project intends to generate. Finally, we must mention that the financial term of the project is not necessarily the execution term of the project.
2. Forecast of incomes and costs
Forecasts are difficult to make-particularly those about the future.
You must indicate your best estimate for your sales income, as well as for your costs. You need to estimate sales prices, unit costs, and quantities you are planing to sell. This is a big critical point in the project cash flow. The projections here are generally very optimistic. In this regard, we recommend you read our articles about overconfidence.
You should also forecast your sales and costs over time, covering the entire project period, considering how they would increase in the future. You can review our article Advices to improve your Forecast (part 2) where we talked about some ways to make projections.
You must fo all of the above for income and costs, all operational, non-operational and financial. Do not forget to pay special attention to the costs of labor, which is where many errors can occur, such as not considering the total costs or estimating the number of people who will have to be hired wrongly.
Also you must be able to differentiate income and taxable and non-taxable costs, according to the tax or tax laws of your country.
Finally, after having made your best estimate, you should include a contingency, what is this? a reserve, which will allow you to cover future deviations in your estimates. Contingency is important and is often omitted from financial models. How is it determined? there are a variety of methods, from rules of thumb to complex methods. Regardless of how to calculate it, we invite you to include it in your project.
3. Initial Investment
Successful investing is about managing risk, not avoiding it.
Every project begins with an investment. In order to carry out the project, you will need to acquire fixed assets: equipment, machinery, furniture, fixed assets, vehicles, etc. You will also have to buy raw materials to start producing and even the initial fills to start operating. You must consider everything you need for your project. The initial investment is recorded in period 0 of the project flow.
However, if the evaluation periods are very long, you should also consider reinvestments of your assets, such as improvements, expansions and replacements.
Just as you incorporate the initial investment, you should consider in the last period of your project, a couple of concepts associated with the investment in assets: recovery of the book value and sale value of assets.
And very importantly, you must exclude sunk costs. These are the pre-project costs, which have already been recorded in the financial statements. For example, a market study or the cost of R&D prior to the development of a product are sunk costs. They are not part of the project.
Do you think it might be difficult to identify sunk costs? Do not worry. It is not as simple as it seems. It is a very common mistake to include them in the flow, so common that it is in our own psychology, but we will talk about this on another occasion.
4. Working Capital
Not only do I have to live, right, I have to get some cash for my troubles.
A very important item that every project must consider is working capital. By this, we are not referring to the concept of WCM (Working Capital Management). We refer to the incorporation of a reserve of money that will be necessary to cover expenses during the first periods of the project.
Sounds obvious? Yes, but it is so obvious that you usually end up forgetting. There are different methods of calculating the working capital of a project, ranging from complicated methods to a few rules of thumb. Regardless of which method you choose, be sure to incorporate it in period 0, just like the initial investment.
The working capital in a project will allow you to operate during the first periods, when the project is not sustainable, that is, when your income does not allow you to cover your costs. In even simpler words, it is your project’s cushion to pay for expenses.
5. Financing or Debt
The great affair, we always find, is to get money.
Some projects are financed with their own funds, which can be profits from previous periods, extra income, etc. However, other projects require external financing.
Financing, in other words, is credit or debt. There are several organizations that are dedicated to issuing debt, such as banks, private investors, venture capitals, start-up incubators, crowdfunding, etc. Depending on the situation of the company that will develop the project, it can also issue shares (for the first time or a new series) or bonds. In other cases, depending on the country, there are state agencies that also provide project financing. All these ways of obtaining financing have different interest rates, which is the return that the investor asks for their money and which for you is the cost of financing.
The financing is added in period 0 of the project flow and the installments are recorded in two lines: interest and principal. If the term of the debt is longer than the term of the project, do not forget to include the payment of the total debt in the last period of the flow, including the fines that, generally exist, when advancing the payment of the debt.
We recommend that you research and analyze various financing options, both total and partial. You can do as many flows as you have options to be able to choose the best options.
Financial model for project
Never take your eyes off the cash flow because it’s the life blood of business.
Once you have all the financial elements you need, you can start building your financial model, which is the step prior to the financial evaluation of the project.
At least, it is recommended to build two financial projects:
Financial Model: Pure project
It is the project figure without financing, that is, thought of implementing it with its own funds.
Financial Model: Financied project
It is the preious model, plus the effects of external financing, partial or total. It is also known as investor flow.
A lack of patience in trifling matters might lead to the disruption of great project.
The financial project model is the tool through which all financial project data is brought together in a finite timeline. Remember that projects end. The objective of this financial model is to calculate the results for each period of the timeline and determine if the project is financially viable, in simple words, if its returns will be greater than its costs.
A good financial model must incorporate the elements that we have indicated. In analyzing each of them it is essential. Any error in any of them will affect the results of the project evaluation. Most of you set unrealistic deadlines, generate very optimistic income projections, or forget about working capital. We invite you not to fall into these mistakes.
There are also bad practices when preparing the project flow for evaluation. A classic example is purposely undervaluing the initial investment, lowering CAPEX, to pass costs on to OPEX. We invite you not to fall into bad practices.
What comes after building the project flow? Once the project flow is done, you must evaluate its financial feasibility. We will see this in the next article.
Do you need advice to build your financial model? We’ve helped several start-ups, entrepreneurs and business in many countries. You can be the next. Contact us, we will do it for you
We are Steering Bird, online advisers in business direction, management and finance. We specialize in business analysis, control and analysis of investment projects, results analysis, processes of budget and forecast, etc.