The financial analysis of the life cycle of a project is called Project Financing. This involves a cost-benefit analysis to determine if the benefits of the project exceed the cost incurred to complete the project. The analysis is done by forecasting the future cash flows of the project and not the balance sheet of the sponsors.
Project financing is more complicated than other alternative sources of financing, but it helps a project sponsor take on risky projects without risking the assets owned by the sponsor and impacting the sponsor’s balance sheet. You can learn more about project financing with the easiest Project Management certifications and levelling up your knowledge.
What is Project Financial in Project Management?
Project Financing in Project Management is defined as an approach of raising long term funds for projects such as infrastructure or services, capital or financial projects. The funding can either be raised by surrendering a part of equity or by raising funds through debt.
The structure of the financing is dependent on the projected cash flows of the project and is independent of the balance sheets of the performing organization.
The sponsors (or investors) of these projects are large corporations that have a high-risk tolerance. The sponsors can be either from the same industry or a government or public company.
This type of financing is used in large scale industrial or infrastructural projects wherein construction is involved. These projects require upfront capital investment, and they generate cash flow only when a phase of the project is completed.
In case of a failure in complying to the loan terms, the lender can take over the project assets and operations.
The process of raising project financials through an off-balance sheet approach is called project financials.
What are project financials: The amount of funds allotted for a project is called project financials. In other words, the total amount of funds you can use to successfully deliver your project is referred to as project financials.
Structure of Project Finance
In order to protect the assets of the performing organization, a Special Purpose Vehicle (or Identity) is created for overseeing the project. The funds for this project or the project financials are directed to this entity. The key features of this approach are off-balance sheet recording and non-recourse financing.
1. What are Project Financials
The amount of funds allotted for a project is called project financials. In other words, the total amount of funds you can use to successfully deliver your project is referred to as project financials.
2. Off-balance Sheet Recording
The debt and liability associated with these projects are not recorded on the balance sheet of the performing organization. They are recorded as a SPV subsidiary.
The provision of not mentioning debts on the balance sheets is lucrative for the performing organization as they can raise huge fundings for their projects without impacting their financials.
3. Non-recourse Financing
This means that in case of a project failure or loan default, the sponsors will have entitlement only on the assets held by the SPV and not the performing organizations assets. Since the risk is high for sponsors, the interest rates for financing the project are comparatively high.
Key Features of Project Financing
1. Capital Intensive Projects: Project financing is ideal for projects that require high capital investment in terms of equity and debt. These types of projects are usually located in developing countries as these projects are taken up for economic development of a country.
2. Risk Management: For the performing organization this is a good financing option as they can transfer the liability and risk to the SPV, by protecting their assets and maintaining the balance sheet. For the lenders or sponsors, they enjoy high margins due to higher rates of interest for assuming the higher risk of the projects.
3. Large Number of Parties Involved: This structure allows to accommodate and involve various parties involved in these projects.
4. Loan Repayment: The excess cash flow generated by the project at the end of each phase, is used to pay off the outstanding loan. This gradual pays off of the loan amount is a relief to the lending organization as part of the debt is paid off gradually.
Main Purpose of Project Financing
In other words, why should a company opt for Project financing, when there are other traditional ways of raising funds, such as corporate finance.
In traditional or corporate finance method, the sponsors (performing organization) raise funds on the basis of their balance sheets. That means the sponsor needs to show to the lenders that they have sufficient assets, or capital to pay off the loan amount in case of default.
In project finance, the funds are not raised on the basis of balance sheet of the sponsor, but on the future cashflows of the project as the loan amount is paid off using the cash flows of the project.
Project financing greatly minimizes the risk of the sponsoring company as the assets of the company cannot be sold to pay off the loan in case of default.
The differences in between corporate finance and project finance is summarized below:
| Dimension | Corporate Finance | Project Finance |
|---|
| Type of capital | Permanent- it is in the form of equity financing. | The funds are provided until the project is completed. |
| Capital investment decisions | The creditors are not involved in this decision, and they do not have complete information about them. | The creditors are involved in the decision making and have complete information about capital investment decisions. |
| Financial structures | The structure is simple, common and easy to duplicate. | The structure is complex and tailored according to project and funding requirements. |
| Operational Cost of Financing | Low costs as the procedure and documentation are standard. | Higher costs as the documentation are complex and gestation period is longer. |
| Basis of Credit evaluation | The overall financial health of the sponsor is evaluated. The balance sheet is the basis of decision making. | The cashflows of the project are considered when making financing decisions. The balance sheet of the sponsor is not considered while making the evaluation. |
| Cost of Capital | Relatively lower. | Relatively higher. |
Stages of Project Financing
There are three stages of project financing:
1. Pre-Financing Stage
- Project Plan Identification: this involves identifying the strategic plan for the project and assessing whether the project is profitable or not. Keeping in mind the risk accepted by lender, this step is performed by the lender for an unbiased result.
- Risk Management: Before the lender invests in the project, it is important to identify the associated risks and also ways to mitigate the risks, if possible.
- Project Feasibility Assessment: Since the loan payoff is dependent on the cash flow generated by the project, it is important to assess if the project can provide sufficient cash flows and is profitable in the long run.
2. Financing Stage
- Financial Arrangements: In order to raise funds for the project, the performing organization needs to acquire loan or give up equity to a financial organization that is willing to invest in the project.
- Negotiation: This is the stage where the loan amount and rate of interest/ valuation are negotiated.
- Documentation: In this stage, the loan terms and agreements are accepted by all parties and are sealed by official documents. All the necessary documentation is completed in this stage.
- Payment: In this stage the lender transfers funds to the performing organization to begin the project operational work.
3. Post-Financing Stage
- Project Monitoring: It is important to monitor the project timely and let the stakeholders know how the project is progressing. It is the project manager’s job to ensure the project is completed on time.
- Project Closure: Once the project is delivered successfully and all the related agreements have been honored, the project is closed officially.
- Repayment: In this stage the project is officially closed, and the cash flow generated from the project is carefully evaluated as the loan is to be paid off from the excess cash flow generated.
Five Basic Steps to Finance Your Project
To adopt project finance process as a means to fund the project, the following steps should be followed:
Step 1: Identify Potential Opportunities
The first step is to identify and evaluate the potential projects that are profitable in future. Once these projects are shortlisted, the management must choose one project that the organization will go ahead with.
Step 2: Estimating Cost
In this stage, the implementation and operating costs associated with the project are projected. In this stage, the feasibility of the project is evaluated, and a decision is made based on the feasibility and returns of the project. This is the stage where potential threats are identified, and their estimated costs are also considered.
Step 3: Identify Technology
In this stage, a study is conducted to assess the kind of technology that is required to successfully deliver the project. Once the technology is identified, the next step is to estimate how much acquiring the technology will cost and how to acquire the technology.
Step 4: Identify Source of Funding
Once the cost to be incurred is estimated, the next step is to identify sources of project finance. In other words, potential lenders are identified, approached and briefed about the project and the cost associated.
Step 5: Implementation
Once a suitable lender is identified and has expressed a desire in collaborating for the project, the legal documents are signed and the funds for the project are delivered. The operational work for the project begins and strategic plans for monitoring the cost and future cash flows are implemented.
There are 4 types of project finance sponsors that we usually come across. They are explained below in brief:
- Industrial Sponsors: These sponsors are directly related to the business of the performing organization. They are huge organizations in a similar industry and have the funds and risk tolerance to fund project.
- Public Sponsors: These sponsors are government bodies and corporations. The main goal over here is public service and economic development.
- Contractual Sponsor: They help in building, developing or managing a project. They are the sponsors that get the work done in a project.
- Financial Sponsors: These sponsors are in the business of lending and are looking for high profits and substantial rate of return by accepting high risk projects.
Sources of Project Financial
Even though there are numerous sources of raising funds, they can be roughly categorized into three categories that are mentioned below:
1. Debt: Debt that is raised through Investment banks is referred as Private debt and has a cheaper capital cost. This is because debt holders are paid on a priority basis. Debt raised by the Government is referred as public debt and has a higher capital cost.
2. Equity: This source of funding involves giving up a part of ownership of the project to various sponsors in exchange of funds. One of the advantages of this source is, these funds do not need to be repaid unlike debt financing.
3. Loan: This can be categorized into secured and unsecured loan. Under secured loan, the assets of the project are held as collateral against the loan. Under unsecured loan, no assets are backing the loan amount and the loan is offered based on the credit worthiness of the project or organization.
Project Financials Examples
Liquid Gold Pvt Ltd. is an old producing company with over 30 years of experience in the industry along with some stock holdings and assets. Ajit, the CEO of the company, wants to work on a project through project financing.
Since the project he is undertaking involves a lot of risks, he decides to establish another firm for this project, Liquid Gold Oil and Energy Pvt. Ltd. This company will be completely owned by the parent company Liquid Gold Pvt. Ltd. and will manage the operational business of the new firm.
When lenders provide funding, they will fund the new form Liquid Gold Oil and Energy Pvt. Ltd. As a result of this, in case the new company defaults on their payments, Liquid Gold Oil and Energy Pvt. Ltd. will be insolvent but the parent company Liquid Gold Pvt Ltd. will not be liable to pay this debt.
How to Maximize the Impact of Project Financing?
In order to exploit the benefits of the Project Financing, there are some important points to note while implementing this approach of raising funds.
1. A Robust Project Management System
In order to avoid cost overruns, schedule delays and manage the cash cycles, the sponsor organization must have a sound project management system, along with efficient project managers. In order to be a professional project manager, you need to acquire relevant education and training in the area. To learn more about the PM certifications, refer to KnowledgeHut’s Project Management.
2. Right Project Financial Metrics
It is important to streamline and select the right financial metrics in order to monitor the cashflows of the project. A project manager should focus on key metrics that impact a project and should attempt to make decision making easy. The project financials should be carefully studied taking all the relevant information for review. It is also important to regularly conduct a financial analysis of the project to ensure the project is on track.
3. Rate of Investment (ROI)
The project managers should focus on increasing the ROI for the sponsors and creditors of the project. Since the loan is paid off using cashflows of the project, at the end of the project it is important to ensure the sponsor gets sufficient returns for taking up the project.
The two most popular certifications for project financing are the PMP certification by PMI and the PRINCE 2 Accredited training. Taking these certifications will help you ace the exam in the first go.
Benefits of Project Financials
1. Better Debt Management: With project financing, the performing or parent company can raise more funding for the project, irrespective of the financial capability of the parent company. The funding is solely dependent on the probability and cash flows of the project.
2. Better Risk Management: The parent company’s assets are protected irrespective of the project success or failure. This enables a firm to be motivated to take up risky projects that are for the economic growth of a country or city. If multiple members are involved, the risk is shared with all the members, and this reduces each member’s exposure.
3. Allows Parent Company to Raise More Funds: Since the balance sheet of the parent company does not include the loan from project financing, the parent company can raise funds for other projects or operations using their balance sheet.
Drawbacks of Project Financing
1. Complex Documentation: Project financing involves lengthy processes and documentation that can make the process difficult to understand and prone to irregularities.
2. Expensive: The higher rates of interest on the loan amount, the due diligence and requirement of qualified professionals, makes this process more expensive than other approaches.
3. Shared Control: The lenders exercise more control on project decisions, which may be a source of conflict for the parent company and the lenders.
Conclusion
The project financial approach is one that can be adopted to fund long-term, large-scale projects which are repaid through the cash flows generated by the project.
This approach offers various benefits and is really useful for developing countries. It provides incentives to companies to take on risky projects that can help in the economic development of a country or society. In case you want to learn more about project financing, enrol in the KnowledgeHut's Project Management certificate course to take a leap in your career.
The off-balance financing protects the assets of the parent company and enables them to take on risky projects. This also eases the process of raising funds for small or fairly new companies, as the large loans are not provided on their creditworthiness, but on the potential of the project.
This approach is also beneficial for the lenders as they enjoy high rates of interest on these loans and since the loan is paid off through cash flows, the loan is repaid sooner than most loans.
