Building a financial model that is fit for purpose requires getting several stages of the process just right. Get the model wrong and the implications can be catastrophic, potentially undermining the success of the project itself.
Readers who are proficient at building project finance models will find that these steps come naturally. This introductory article is aimed at readers who are new to building project finance models. We will follow this article with in-depth discussions of each of the three steps, which will be of more interest to readers already familiar with project finance modelling.
However, keep reading if you are faced with modelling a project for the first time and need guidance on the steps to take. In principle, we suggest these three points are essential to building a project finance model that succeeds:
1. Determine the rationale for the model
Models vary in detail and rigour. Understanding what level of complexity to aim for from the outset can speed up the model building process. Overreaching in terms of complexity can lead to a model which is not usable in the real world. On the flipside, not meeting the expectations of your audience means that your model falls short.
Therefore, it is crucial to first determine who it is that will be using and consulting your model, and what it is that they expect to achieve with the completed model. We suggest that you think about these two points before you even start to construct a project finance model:
Who is the audience?
Different audiences will want to see different aspects of a project modelled. For example, a bank will want to see how your model performs against sensitivity tests that include financial market variables. A model built to accompany an application for a government subsidy will focus on other aspects of the project. Build a model that meets the requirements of your audience.
What is the motivation for the model?
A project finance model can perform different roles depending on the user and therefore require differing levels of rigour and complexity. Models used for internal estimates will require a less painstaking approach compared to a model that is used by a bank to judge the risk of a large loan. As much as rigour brings accuracy, it does come at a cost in terms of time consumed and overall usability.
Clarifying what it is you want to achieve with the model, right at the start, saves time throughout the process of building the model and ensures you end up with a model that is fit for purpose.
2. Understand what makes a good model
In setting out to build a competent project finance model it helps to understand what makes for a competent model in the first instance. Again, the implications of getting it wrong can be significant, whether this entails time-consuming bug-chasing or indeed more serious financial implications in the long run. Consider these points:
Overall model correctness
Project financing is a complex arena and modelling a project is not simple. Correct, functional models must cover all relevant variables and calculate results accurately. There should be no unexplained estimations or grey areas, and where uncertainty exists the model should ensure that the user is expressly aware of this uncertainty – by expressing ranges in outputs, for example.
A model must be able to withstand a degree of user abuse while presenting itself in a way that steers the user clear from using it incorrectly in the first instance. Just like any reliable application, a reliable model can deal with usage patterns that deviate from the strict, narrow expectations set by the model developer.
Easy to understand, easy to audit
It is likely that external parties will need to inspect a model for accuracy or change a model at a later point in time. This point ties into expectations around usability, but it goes further in that the formulas that do the behind-the-scenes work should be sensibly constructed. Similarly, the overall construction of the workbook must follow spreadsheet good practice.
Again, a project finance model underpins the key financial aspects of a project, acting as a pillar that supports decision making throughout the execution of the project. A glitch-free project finance model is, therefore, an imperative.
3. Choose the right model builder
Is it realistic to model the financial aspects of a complex project internally? How do you choose external help, if needed? Constructing a project finance model, particularly in the case of complex projects, benefits from the insight that is gained through experience and here project finance experts such as Operis have the advantage. Regardless, in choosing a model builder you should bear in mind these points:
Building a reliable model that withstands scrutiny is not easy, particularly where a model involves a wide range of inputs and outputs with complex interactions. Consider the technical capabilities of the model builder: can the individual or firm handle extremely complex spreadsheets? Can you trust that their calculations are correct?
An issue for internal teams, in particular, bias can lead to project finance models that do not always accurately reflect reality. Due to bias a model may make unrealistic assumptions or leave out risk factors that will undermine the accuracy of the model. In fact, it is not uncommon for a party to a project to demand that a project’s financial model is built by an independent firm to ensure accuracy.
Some firms that have the capabilities to build complex project finance models can support their work by offering liability cover in case a model is found to be defective. A model builder can offer a compensation guarantee if and only if the quality of their work allows it. Liability can be as high as seven and eight figure amounts. Providing liability can offer substantial reassurance to those party to a project.
Modelling of simple projects could be handled by an internal team but large and complex projects with many stakeholders are usually better handled by independent modellers that have the insight, experience and foresight to build a model that is fit for purpose.
Where to start?
When it comes to large-value, complex projects a hap-hazard approach to project finance modelling is clearly inadvisable. Yes, it is easy to quickly cobble together a spreadsheet akin to a back of the envelope calculation, but if a project is to stand on firm financial ground it will require a solid, dependable project finance model.
Particularly where a company has little experience in project finance modelling it may be advisable to retain the services of a firm that has the necessary expertise in building project finance models. Operis can assist in modelling even the most complex projects within a timeframe of as little as five to six weeks.
Not sure where to start? Contact Operis for advice, or indeed end to end project finance modelling.