The Public Spending Code: D. Standard Analytical Procedures
Carrying out a financial analysis
- A general financial analysis identifies and quantifies financial inflows and outflows.
- Exchequer cash flow analysis is a specific financial analysis which takes into account direct and indirect flows which impact on the Exchequer. This is an important type of analysis because it isolates the cashflow impact of spending proposals for the Exchequer, regardless of which part of the Exchequer is affected by the cashflows.
- Affordability analysis – an assessment of whether or not a project is affordable with reference to expenditure ceilings, the timing of payments and the opportunity cost of investments.
- Analysis of sources of funds – a breakdown of the sources of finances for a given project.
A clear distinction must be drawn between the general financial analysis which should be carried for every spending proposal and which is reflective of inflows and outflows for the sponsoring agency and an Exchequer cashflow analysis which takes a whole of Exchequer perspective and which should accompany every CBA carried out.
|Financial Analysis||Economic appraisal|
It is important to note that whereas a CBA may illustrate that a proposal would generate a net benefit for society, the distributional analysis of the costs and benefits as between the Exchequer and private citizens can vary. For example, a project may involve significant costs to the Exchequer and a net benefit for society but the extent of the Exchequer costs are such that the project is unaffordable or the project causes significant costs for other components of the Exchequer other than the Sponsoring Agency.
- Identifying and estimating the financial cashflows
- Assessing financial sustainability i.e. can a project’s revenues cover its costs and will a project run out of cash
- Determining that part of the investment cost which will not be recouped by net revenue
- Calculating performance indicators such as the Net Present Value (NPV) and Internal Rate of Return (IRR)
- Assessing the funding sources (public, private, EU) for the project and examining the return on capital for different sources of funds.
Who should carry out a financial appraisal?
- A financial analysis from the perspective of the sponsoring agency
- An Exchequer cashflow analysis
When to undertake a financial appraisal?
- Identify the time horizon (usually the same as the CBA time horizon) based on the economic useful life of the asset.
- The incremental inflows and outflows should be identified for each of the main options. Figure 2 sets out some typical types of inflows and outflows.
Figure 2 Main types of cashflows in a financial appraisal
|Investment costs||The initial capital outlay, usually a once off cost incurred at the outset of a project|
|Operating costs||Ongoing running costs for a project e.g. utilities, labour, material, accommodation costs, administrative costs|
|Start up costs||Preparatory studies, consulting, training, R&D,design, planning|
|Decommissioning cost||Costs associated with removing an asset from use|
|Operating revenues||Revenue from charges or tolls / dividends|
|Residual value||The value of an asset at the end of its useful life or at a point in time, usually a once off value. The residual value of an asset should usually be the discounted value of net future revenue after the time horizon. It can also be considered as the value of the asset in its best alternative use e.g. scrap.|
|Savings on unemployment payments (indirect)||These can be relevant but are not amenable to reliable costing. They should always be directly attributable to the project i.e. savings on welfare payments are not included if these savings occur regardless of the project going ahead|
|Additional tax revenue (indirect)||These can include income tax, VAT and corporation tax but should be included only to the extent that these are net of deadweight i.e. the revenue is additional revenue which would be not received in the absence of the project.|
The analysis should take into account flows both directly and indirectly associated with proposals. Additional expenditure for which the sponsoring agency is not responsible but which are project related should be included. The costing of indirect flows should be strictly net of deadweight and displacement. Often, only a low proportion of social protection savings or additional tax revenue can be directly attributed to the project.
- Depreciation is an accounting transaction and not a cashflow and should be excluded from the financial analysis
- Reserves are also not cashflows.
- Other accounting items should be ignored such as :
- Sunk costs – costs which have already been spent or committed and cannot be changed by the decision under consideration. They should be ignored. However, the quantum of sunk costs to date is a noteworthy point of information in terms of progress under the project to date and should be noted separately
For a commercial semi-state organisation carrying out a financial analysis, the profit and loss projections should also be included. This would show the impact of a project on the main revenues and costs of the organisation. Similarly, the balance sheet projections should also be shown by illustrating the impact of the project on the finances of the organisation with particular emphasis on its working capital, debt and resources. Commentary should be included where necessary.
- Quantify the costs
Cost estimation is difficult and often requires the input of accountants, economists and other specialists. Costs should be based on the most accurate data available and should be as realistic as possible because underestimation of costs can be a common problem with appraisals.
- Identify the pattern of these flows i.e. in what years do these flows arise.
- Discount the value of these flows to take account of the time value of money using the official Department of Public Expenditure & Reform discount rate (see section E of the Public Spending Code).
- Carry out a sensitivity analysis of the most critical cost and revenue variables
- Report the results
There should be a clear link between the financial analysis and the CBA so allow private and social costs and benefits to be separately identified.
- Not including residual values
- Incorrect valuation of residual values e.g. overly optimistic assessment of residual values given that residual values are difficult to predict
- Underestimation of costs
- Increases in costs from initial project conception to final delivery are common. Cost increases must be reconciled back to show or explain the reasons for the cost increases. Cost estimates must include all initial capital costs and lifecycle costs (in detail)
- Errors in the timing of cash inflows and outflows
- Not including cashflows which may affect other Exchequer components
- Overestimating the income tax receipts/benefits and social protection payments savings of projects
- Mismatching real/nominal values with real/nominal discount rates
Appendix A Sample Exchequer cashflow analysis for a capital project
Financial analysis template
|Revenue from charges|
|Planning and design|
|Customs and excise|
|Total tax impact|
|EU Finance passing through the Exchequer|
|Discounted net cashflow|
* The first four years are shown for indicative purposes, appraisal timeframes are generally longer
Analysis of sources of funds
|EU finance passing through the exchequer|
|National Private capital|
|Total sources of finance|