The Public Spending Code: D. Standard Analytical Procedures Carrying out a financial analysis D.02

The Public Spending Code: D. Standard Analytical Procedures

Carrying out a financial analysis


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Document Summary: This document provides a high level guide to carrying out a financial analysis. Financial analysis is an important element of overall appraisal, and focuses upon the cash implications of particular projects or programmes. Every spending proposal must include a separate financial analysis with the level of detail commensurate with the extent of expenditure involved. A financial analysis is usually undertaken from the perspective of the sponsoring agency.There are different forms of financial analysis depending on the perspective taken. In addition to a financial analysis from the perspective of the sponsoring agency, an Exchequer cashflow analysis is also an important analytical tool. This analysis considers all direct and indirect flows which impact on the Exchequer and not just the sponsoring agency. An Exchequer cashflow analysis must accompany every CBA (mandatory for projects over €20m). Financial analysis is also of relevance for commercial semi-state companies which are appraising investments. This guide also explains the differences between a financial analysis and an economic appraisal and describes the main steps in carrying out a financial analysis. The main application of this guide is for capital projects but the general principles also apply to current projects as an understanding of financial flows is critical to any spending proposal.
Detailed appraisal is a key stage in the project or programme lifecycle. This document provides introductory guidance on how to carry out a financial analysis. A financial analysis or appraisal is an important building block in the overall appraisal process and acts as a first step before carrying out the economic appraisal. A financial analysis only considers financial cash flows whereas an economic analysis in the form of a CBA examines all costs and benefits for society and not just the direct financial flows arising from the project.
It should be noted that financial analysis is a broad term which can cover many different types of assessments carried out for different purposes. Some of the variants of financial analysis used for appraisal purposes include:

  1. A general financial analysis identifies and quantifies financial inflows and outflows.
  2. 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.
  3. 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.
  4. 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.

This document describes the main features of financial analyses, explains the difference between financial appraisal and economic appraisal and outlines the main steps involved.
What is a financial analysis?
Financial analysis is a method used to evaluate the viability of a proposed project by assessing the value of net cash flows that result from its implementation. Such appraisals are routinely carried out in the private sector by companies to assess whether investment projects are commercially profitable.
Financial analyses are also relevant for the public sector, particularly where there is output to be sold and charges imposed e.g. light urban rail, water charges. A financial analysis allows for an assessment of the budgetary impact of projects by looking at the pattern of project related cash flows. Financial analyses are particularly important for appraising PPP projects, large projects with complex financing structures and for assessing the net return of projects developed by commercial semi-state companies. Nevertheless, any sponsoring agency must be able to quantify the financial cashflows associated with any spending proposals.
Financial analyses are prepared using many of the same principles which apply to economic appraisal techniques such as CBA e.g. incremental flows and the calculation of discounted cash flows.  Although some elements are shared, financial analysis differ from economic appraisals in the scope of their investigation, the range of impacts analysed and the methodology used. An economic appraisal such as CBA typically considers all the social and economic impacts on society and not just the cash flows directly affecting the sponsoring body or the Exchequer. In addition, CBA also considers costs and benefits for which market values are not readily available whereas a financial appraisal focuses only on cash flows. Figure 1 overleaf sets out the main differences between a financial appraisal and an economic appraisal. (More detailed information on economic appraisal and on CBA in particular, is located at document D03 – Guide to Economic Appraisal: Carrying out a CBA)
Figure 1           Differences between financial analysis and economic appraisal

Financial Analysis Economic appraisal
  • Considers only financial cashflows
  • Used by the private sector but can also be used by the public sector
  • Focuses on financial flows directly affecting project sponsor and/or Exchequer
  • Considers economic costs & benefits
  • Used mainly by the public sector due to the focus on net benefit for society
  • Focuses on economic and financial flows affecting society

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.

Purpose of a financial appraisal
A financial appraisal focuses on financial cashflows as opposed to economic flows and in particular considers profitability and sustainability. The objectives of a financial appraisal  can include:

  • 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[1]
  • 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?

Sponsoring agencies should carry out financial appraisals.  As outlined in Public Spending Code A.02 – Clarify Your Role, these are normally Government departments, offices and agencies or any body in receipt of public funds.  Financial appraisals are the main focus of the investment appraisal[2] process for commercial semi-state companies.
As previously stated, there are at least two types of financial analysis which must be carried out for projects over €20m:

  • A financial analysis from the perspective of the sponsoring agency
  • An Exchequer cashflow analysis 

When to undertake a financial appraisal?

A financial analysis incorporating an analysis of cash flows, even at a simple level, should be carried out for all spending proposals regardless of scale because an understanding and quantification of financial flows is critical to the approval decision. The level of detail involved should be commensurate with the scale of expenditure.
The financial analysis should be carried out as one of the first steps in the overall appraisal stage because an understanding of the pattern of the cashflows is a critical building block for the overall business case as well as the CBA.
It is useful to distinguish the financial analyses from the economic appraisal because the former acts as a foundation on which the CBA is built, particularly regarding the estimation of project costs. In the case of an Exchequer cashflow analysis,  it also allows for a separate consideration of the budgetary impact of the project on cashflows.
Main steps in carrying out a financial analysis
The main steps in carrying out an Exchequer cashflow analysis are set out below. The same basic steps also apply to a financial analysis from the perspective of the sponsoring agency with the exception that broader Exchequer cashflows are excluded.
  1. Identify the time horizon (usually the same as the CBA time horizon) based on the economic useful life of the asset.
  2. 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

Outflows Description
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.

All sources of finance, including EU finance, should be included. The financial appraisal should also include all attributable overheads.
There are different ways of categorising costs. In addition to the direct/indirect categorisation, it may also be useful to categorise costs into variable, fixed and semi fixed groupings. Exchequer cashflows should be separately identified.
It is important to note that the following flows should not be included as part of a financial appraisal.

  • 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
    • VAT[3]

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.

  1. 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.

Costs should be set out in constant prices to be consistent with the application of the real discount rate.
  1. Identify the pattern of these flows i.e. in what years do these flows arise.
  2. 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).
  3. Carry out a sensitivity analysis of the most critical cost and revenue variables
  4. 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. 

An indicative sample Exchequer cashflow analysis is set out at Appendix A.
Common errors
It is a common problem to conflate financial flows with economic flows and include them in the same analysis. Other issues to avoid include:

  • 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[4]
  • Mismatching real/nominal values with real/nominal discount rates

Appendix A       Sample Exchequer cashflow analysis  for a capital project

Financial analysis template

2012 2013 2014 2015*
Revenue from charges
Residual value
Total inflows
Equity participation
Operating costs
Other maintenance
Investment costs
Planning and design
Decommissioning costs
PPP payments
Total outflows
Indirect taxes
Carbon levy
Customs and excise
Direct taxes
Income tax
Corporation tax
Total tax impact
PPP Payments
EU Finance passing through the Exchequer
Other flows
Net cashflow
Discounted net cashflow

* The first four years are shown for indicative purposes, appraisal timeframes are generally longer
Analysis of sources of funds

2012 2013 2014 2015
EU finance passing through the exchequer
Exchequer contribution
National Private capital
EIB financing
Other loans
Total sources of finance

[1] Sustainability occurs if the net flow of cumulated generated cashflow is positive for all the years considered
[2] Commercial semi-states should also assess the impact of a project on the profit and loss account and the impacts on the organisation’s finances including working capital, debt and reserves.
[3] To the event that additional VAT revenue is generated as a result of the scheme, this revenue can be included but only if it is strictly additional and net of deadweight. In general however, VAT on inputs can be excluded as it is a transfer payment unless there are differences in tax treatment between options.
[4] These indirect flows must always be calculated net of deadweight and care is required.