In this post, I want to talk about things that people say about the financial model, but it actually makes no sense. When you are faced with these kinds of arguments, I want you to be well prepared to argue against these kinds of mindsets which are irrational and are mainly because some people do not value analysis and are just focused on fulfilling a checklist.

Watch my video on “Financial model is more than just a document in a checklist“

Throughout my career as a financial modeler, I heard in many instances people saying that in the real world they do things in one way but for the purposes of the financial model they reflect it differently. They might be right in many instances but there are cases where this does not stand. I am advocate of simplicity but you don’t simplify when it is not justified

In this post, I want to share with you some of the examples and show you how I would respond to them:

  • Modeling of Major Maintenance:

Let’s say you have a project and lenders require a Major maintenance reserve account to be in place. The major maintenance account is not included in the model and when you ask for it. You get this answer:

Argument: ” We have included an annual budget for maintenance in our operating expenses. the cash impact is the same and therefore for the purpose of simplification, we did not model MMRA).”

Your counter argument can be:  ” financial model is a contractual document referenced in the term sheet, it should reflect the reality and be in line with project documents, therefore although the cash impact will be the same, we still require having the MMRA to be included in the model”

For more on MMRA, check the below:

https://www.eloquens.com/tool/7GzdHY9n/finexmod/financial-modeling-of-major-maintenance-reserve-account-with-manual-and-excel-template/?ref=FinExMod

  • Inflation:

Argument: ” It’s difficult to project inflation over 25 years over the life of the project, therefore for the purpose of simplicity, we did not include inflation in the model and the model is reflected in real terms”

Counter argument: ” there’s a certain level of uncertainty attached to almost all inputs reflected in the model. That is why we will do sensitivities to see the impact of changes in different inputs on the model outputs.  Therefore, we recommend reflecting inputs in real terms, as per the project contract but then define escalation rates as inputs and apply them to real values. Sensitivities on escalation and inflation rates can be applied to see the impact of any deviation from base case assumptions on the model results.

For more on why you should include inflation in your model, please refer to the below article:

https://www.linkedin.com/pulse/should-i-model-real-nominal-jonathon-power/

  • Currency:

Issue: “all cash inflows and outflows are reflected in USD in the model”.

Problem:” Project revenues will be paid in local currency and Loan will be denominated in USD”.

The choice of model currency is an important decision. However, what is recommended is to reflect all cash inflows and outflows in their original currency of invoice and billing and then converted to the model currency, this way you can do sensitivities on the exchange rate and see the impact of different currency devaluation or revaluation on project main metrics.

  • Refinancing:

To include or not include refinancing in the base case financial model is something that is a question to me. I have mainly worked on projects in Africa, and we never include re-financing in our base case models, however I know in projects in Europe, re-financing is mainly included as something that will be part of the project and included in the base. I will leave this as an open question to you. However, if you want to know how to incorporate refinancing into your project finance models check out my suggested solar PV temple here:

https://www.eloquens.com/tool/RZYLiaBv/finance/solar-project-financial-modeling/project-finance-solar-pv-model-with-re-financing/?ref=FinExMod

  • Annual model periodicity:

Can you work with an annual model? The answer is no. Most of the time debt repayments are either on quarterly basis or on semi-annual so the model should follow the debt repayment periodicity. This is because all covenants need to be calculated on a periodic basis and will also be monitored accordingly. Even if you are working on a project which is funded with 100% equity still you want to have periodic projections especially during construction. The argument against having an annual model can be formulated as below:

The recommendation:

– Recommend having periodic model with flexibility to change model periodicity by creating flags and counters

– Have projections on a periodic basis but include a summary annual sheet to see the project’s performance at the end of each year.

Why it is recommended:

– To reflect debt repayment dates and calculate ratios as per loan agreement

– For monitoring purpose

Now, I would love to hear from you.

  • Do you have other examples that you can share with me?
  • Have you come across an issue that justifies the financial model to be different than what happens in the project or as reflected in the contract?