6 Questions on the Path to Financially Justified Projects: Developing Cash Flow Models – Part 1
Abstract: Projects are financial and strategic investments that exist to deliver value.Cash flow modeling is a required and essential step to produce return on investment (ROI) financial measurements that support the project selection process. Examined here are finance topics, specifically six key questions (Number 1 and 2 below) non-financial personnel need answered at the onset of the process to assist in producing reliable and accurate cash flow models to transform the project manager into a strategic value-enabler and profit creator.
Projects are financial and strategic investments initiated to improve shareholder value and are only successful when they deliver their expected business returns. Senior leaders – the executives above the project level – realize this, think in these business terms, and crave financial information for decision purposes. To be a strategic value-enabler and profit creator, a project manager must be capable of conveying the big picture of their projects in both business and financial terms. Developing these skills will enhance your ability to manage the delivery of value.
Let’s begin with a hypothetical business scenario. You’re working on a significant project. It’s one-third complete. The company hires a new CFO, and in an effort to get up to speed quickly, a meeting is called. You are asked to review the potential project results because the investment required for this particular project is quite large. Are you prepared to discuss your project’s ROI financial measurements (e.g., ROI, IRR, NPV, Payback) or will you freeze like a deer in the headlights? Did you prepare a cash flow model that summarizes your project’s financial value to the organization – financial projections that your superiors are likely to take seriously? Without this knowledge, how do you really know if you are using corporate funds and resources wisely?
Project professionals are quite proficient at managing project management’s triple constraints – scope, cost and schedule – yet they often fail to grasp the big picture. Often the thrust of their efforts is on project execution, when it should be (more appropriately so) on value attainment. By sharpening your understanding of basic financial concepts, you can greatly improve your ability to project and articulate project benefits in quantifiable business returns.
If your project is not in alignment with the organization’s financial and strategic goals, simply ask yourself: why bother? For this reason, the knowledge and skills needed to quantify projected returns are imperative for any successful project manager. This article aims to acquaint project managers with the information and knowledge required in advance of efforts to build a cash flow model. The intent is to increase comprehension and make developing models a lot less arduous, eliminating many of those “I don’t know how to proceed” roadblocks. Armed with this knowledge, you will be one step closer to producing an accurate financial representation of your project.
You will need to know the following:
What is the accounting method used for depreciating assets?
To calculate key financial measures needed to assess a project’s value contribution requires that you identify project assets and determine if, and how, they should be depreciated. To account for depreciation, a well-developed financial model must reflect depreciation expenses for assets purchased/placed in service by the project.
Generally accepted accounting principles (GAAP), which vary from country to country, represents the standard in the United States for creating financial reports. The standards require that the value of an asset be expensed or “allocated” over the useful life of the asset (i.e., over the time that it is used to generate revenue and profits) according to “The Matching Principle,” which essentially allows for a more objective analysis of profitability.
The Matching Principle is a fundamental accounting rule in which the income or revenue (cash inflows) match up with associated expenses (cash outflows) to determine profits in a given period of time – usually a month, quarter or year. In other words, cost is recognized (for accounting purposes) at the time when the benefit that the cost provides occurs. This differs from when the actual expense occurs during project execution. The theory surrounding this is simple. For example, if your project requires the purchase of a specialized piece of equipment, which is expected to generate revenues over the coming five years, it makes sense to allocate (match) via a depreciation schedule, the purchase cost of the equipment over the given time period it is expected to produce revenue. Done differently, the numbers on the organization’s income statement could result in misleading or false conclusions.
There are different accounting methods an organization can use to depreciate assets. The more common methods include straight-line, fixed percentage, and declining balance, with straight-line being the most common and the easiest-to-use method. With straight-line, the original asset cost, less its salvage value (at the end of its useful life) is expensed in equal increments over its depreciable period. An asset may or may not have an estimated salvage value at the end of its useful life. For example, a depreciation expense of $12,000 per year ($1,000/month) for 5 years using straight-line depreciation may be recognized for an asset that costs $60,000 with no salvage value at project completion. The depreciation expense becomes a write off (over the asset’s anticipated life) against profits in the same period.
Depreciable assets include equipment and other tangible assets. Computing depreciation may vary according to the asset class, accounting standards, length of the depreciable lives of the assets, or the tax laws of a particular country. Supplies and other such items to be used within one single year cannot be depreciated and are expensed during that year.
The ability to expense an asset is useful for tax purposes. Generally, the cost is allocated as depreciation expense. Depreciation is a noncash expense, therefore reducing the total tax liability for the proposed project. Obviously, this is a good thing, since depreciation lowers reported earnings while increasing free cash flow.
What is your company’s income tax rate?
Taxes are a real expense, have a significant impact on project results, and consequently lower overall financial benefits that projects achieve. For this reason, cash flow models are built on an after-tax basis. After-tax cash calculations are needed to discount future payoffs (future cash inflows) to present values, which in turn provide the means to calculate additional metrics you will require.
If your firm’s tax rate is 30%, a $350,000 operating gain generated by a project becomes $245,000 once taxes are taken out. However, if that income tax rate was 35%, the $350,000 financial gain then becomes only $227,500 ($17,500 difference no longer contributing to bottom line results). There may be time-period(s) when the project loses money, in which case the appropriate tax rate is applied to the operating loss, thus lowering the tax liability. Reflecting the impact of taxes produces ROI financial measurements that are more precise. You will therefore want to know your firm’s tax rate.
Keep and eye out for Part 2, to be published August 8th.