What is an operating model
Projects at different phases of their lifecycle need different types of models.
A project that is in the planning phase and close to securing financing needs a model to help shape the debt structure. We call this the financial close model. A project undergoing a restructuring of existing financing needs a refinancing model.
Both financial close models and refinancing models are examples of transaction models – a model used on a specific date to enter into legal agreements around future debt. After that date, the model ceases to be updated, though it holds the original base case against which reality will later be compared.
An operating model is a bit different.
It is used on an ongoing basis for monitoring the asset’s performance (and might also be called the monitoring or budget model). It is updated periodically (usually quarterly or semi-annually) to reflect the latest views on the asset.
When an operating model comes into play, the project has already gone through planning and has a fixed financing structure in place. It is usually most or all of the way through construction and is, or soon will be, earning revenues. Those revenues mean that it can start making payments to debt holders and shareholders.
Why do you need an operating model
An operating model produces medium to long-term cashflow forecasts and helps reassure everyone involved of the long-term health of the project. It is used to calculate debt cover ratios for any senior debt the project holds. These must be calculated (and result in an acceptable number) before the project is permitted to distribute cash to shareholders. Shareholder return metrics, such as IRRs or DCF valuations, also require cashflow forecasts until the end of the project’s life, and the operating model is the source of these forecasts.
It is likely that you will also have a short-term budgeting process for managing cashflows that has a more detailed line-item breakdown. This is not usually held in the operating model, but you will want to ensure that both forecasts tell a similar story about the coming year.
How do you build an operating model
An operating model will be updated many times, and usually by an employee of the project rather than by someone who is a financial modeller by trade. An operating model must therefore be designed with this user in mind – it must be light and easy to use, and the process for updating the inputs must be as straightforward as possible.
An important difference between an operating model and a transaction model is that as time moves forwards, an operating model must be able to overwrite forecast calculations with historic data. The input format for the historic data is a key design choice, as it will need updating regularly. It should take inputs in whatever format the project already has (which might, for example, be trial balances or financial statements). The historic inputs must feed into the calculation of every line on the cash flow, profit and loss and balance sheet in a sensible way. Because this interface is so structural to the integrity of the model, we would always recommend building an operating model from scratch – it’s very hard to retrofit this well into an existing model.
The other reason to start from scratch is that the choices around the financing structure that are necessary in a transaction model aren’t relevant once the debt has been locked in. Omitting this from the operating model significantly reduces the complexity of the logic and the size of the model.
That said, don’t be too quick to throw away the financial close model. It is a very useful reference point for cost assumptions and calculation methodologies, especially on the revenues and costs side.
The model should contain easy-to-interpret structural and commercial checks so that the model user can take appropriate action if anything is broken. And finally, it should be accompanied by or contain a user guide that will help any current or future user to update it.
