Building investor-grade financials

What makes a financial model complete and compliant with investor expectations, puts your project in the best possible light, and upholds established accounting standards? Most experienced investors will tell you “We’ll know it when we see it,” as there is an art to presenting numbers in a way that enables the reader to accurately pinpoint risk versus verifiable reward. But there are also heuristics and guiding principles for building and validating complete and investible pro forma financial projections.

Jargon alert: some of the words and phrases used in this brief article are specialized terms understood by finance professionals. For non-finance managers, look up anything new or seemingly ambiguous at glossary.

In3’s senior personnel are formally trained (Moody’s Analytics and as loan originators for the US government DFC, World Bank IFC and regional development banks) and specialists in this area. That doesn’t make us “right” but does inform the following guidelines and criteria for evaluating financial projection quality and efficacy, while giving the project’s proposal for funding the best possible odds of gaining support — either from our partners, or others you may be able to access. See also Project Financeability Checklist.

A separate matter is how to summarize and present financial modeling work to show the key facts that are of greatest interest to investors. For a few hints on this, consider our guide to Sources & Uses Statements (with numerous examples on page 3) a solid starting point.

A complete financial model has the following characteristics:

1. Complete accounting of costs, where possible, aided by third party validation of estimated costs, actual bids or experience-based costing by a competent estimator, such as an EPC firm or General Contractor (more). Why not do this estimating yourself? You can, but history shows that we humans tend to underestimate or overlook certain cost categories, due in part to the bias inherent with the understandable desire to show a project’s financial feasibility. Better to first disprove your theory (tell the unvarnished truth to yourself and your team), then address that reality with plausible solutions. If it was completely straight-forward and as easy, would it be worth doing? Going deep into the cost accounting is one area that deserves more than back-of-a-napkin window dressing. The window of opportunity does not open for everyone.
   Note: Although we do not require feasibility studies for projects that our partners would agree to finance, such precise estimating can be extremely valuable. Builds confidence and clarity while accounting somewhat for the inherent bias of WANTING to make a project work.
2. Transparent and properly calculated assumptions. Instead of just hard-coding numbers that involved calculated estimates, where possible (even if seemingly impractical to do this), show the formula as well as the calculated basis and describe any underlying methods, metrics, market, and/or benchmark comparison that were used in constructing the estimate or resultant forecast. Extra points (faster due diligence, fewer questions, more of a self-guided tour):
   • Put all assumptions in one place. User-friendly models that group together what are assumptions (inputs) as distinct from estimated performance, metrics (such as results indicators, performance ratios, summarizing statements, etc.), or other “outputs” are best presented on different sheets.
   • Put controlling variables in a visible cell — which also makes it easier to update the model due to fluctuations in currency exchange rates, prevailing rates of interest, presumptions about how inflation would affect inputs or output, tax venue-specific factors, in a cell that is visible and labeled
   • Show your work — using sensitivity analysis, provide additional footnotes or other documentation (even if separate from the live spreadsheet / workbook / model) to enable self-guided access to the key assumptions. Do not just present your assumptions in the model as “hard coded” numbers, but show the underlying calculation, as well as the source(s) used as inputs, or reference and explain this somewhere close-at-hand so that the funder can easily access. Trace values used back to their source(s), and disclose your methodology, or at least explain the logic employed to support any critical inputs and anticipated performance.
     For example, if modeling utility-scale solar/PV, provide the source of the estimated GWH/year solar irradiance.
   • Use the generally accepted accounting methods for your region and country. In general that’s GAAP in the US, Mexico and other parts of the Americas or IFRS in Europe, Australia, Canada, Japan, India, and Singapore (see below for more on GAAP and IFRS). Such standards and “best practices” are like a language shared by other professionals. DO NOT INVENT YOUR OWN METHOD. This will just get in the way and cause delays.
3. Provides annual financial statements — projected annual income statement, balance sheet and cash flow statement. Properly organize and present a Sources & Uses statement as part of the project’s executive summary. Include and support any prior year actuals adjacent to the projections. This is an intrinsic part of the presumed IFRS or GAAP accounting mentioned above.
4. Anticipated Results, or upside rewards, including (when applicable) Social/Environmental Benefits: Include industry-standard ratios and metrics such as Internal Rate of Return (the project’s overall, “unlevered” IRR), Debt Service Coverage Ratio (DSCR) or Cash Available for Debt Service (CADS) and net operating margins for the life of the forecast. Indicate the number of years used for each metric. Use standard methods (often fine to lean on MS Excel for those calculations).
   • IRRs are particularly important to investors as a performance benchmark. The number of years used is an important disclosure — typically 10-25 years would mirror the useful life of the project’s assets or life of the financing. If an IRR is not at least on par with standards for a given project’s industry (more), or if well above or below those standards, expect questions.  Better, proactively explain and show why the IRR is either materially above or below the industry standard.
   • Note that Equity IRR (eIRR) is more subjective, and not widely respected or used for this reason. If you show us eIRR, be sure to disclose the basis. It is not a substitute for overall/unlevered IRR. You must show both forms of IRR, and do not include any “terminal value” (selling price) in IRR calculations. Exception: commercial real estate with a revenue model that sells off the buildings (homes, condos, hotels sold to a reputable and creditworthy brand, etc.) may include the terminal value along with verifiable market studies or offtake contracts.
   • If seeking a loan, Debt Service Coverage Ratio (DSCR) should be at least 1.25 for the life of most long-term loans. Document how many years were used to calculate the DSCR average.

Fully upholding IFRS or US GAAP accounting standards

You may want to use as a basis for these projections a spreadsheet model template or similar tool that has been rigorously tested and proven to uphold international accounting rules, such as IFRS. If yours is not based on such a model, consider getting it audited by a certified/accredited financial services firm or accountancy that specializes in project finance. The vetting report and signed statement from the accounting first will at least show you striving to uphold these unambiguous professional standards.

Warning: Unfortunately, not every certified/chartered accountant, or accounting firm, even those recognized as top in their respective field(s), necessarily knows project finance. There are traditions and cultural norms (practical expectations based on recognized patterns and practices) that must be met in order to succeed and convey the strengths and weaknesses (remaining risks, especially) that tend to go well beyond columns and rows, even in a most well-designed spreadsheets. In other words, interview service providers and discover what they have achieved successfully in the past, what mistakes they have made and learned from, what is their verifiable track record and operating history?

This work, done right, can be very challenging, even to experts. It involves an analytical overlay of the key considerations and a hierarchy of facts, manner or “style” of disclosure (such as no “hard coded” values in cells when an Excel formula would instead transparently reveal how the value was derived), finesse and social acuity with the presentation of facts (communication based on audience expectations and traditions, whether or not explicit) and other facets that reflect sound business judgement. These “soft” elements are at once overarching and practical, thus essential, when developing compliant financial models that will pass due diligence and win the support of investors and/or lenders.

This can be a simple yet subtle matter of interpreting and selecting the relevant modeling results to be summarized and presented, while doing so in a way that allows easy drill-down capabilities by the recipient. Ultimately, the funder has to understand and accept what’s presented to them without digging for answers to any number of common-sense questions, so making this discovery process a self-guided tour becomes paramount, and can save tremendous time with establishing credibility at the outset, avoiding sending the wrong message(s) unintentionally (sometimes irrecoverably), then onward through due diligence completion and negotiation of terms.

Helpful Tips

If seeking to sell equity and later buy it back (or sell the funded assets outright), be sure to point to any industry standard ratios (such as Price-Earnings or PE) to inform equity investor-related valuations.

Although being “bought out” is an option with most project financiers (sometimes also called a “claw back” provision), and not uncommon in venture finance, typical project finance scenarios take on an equity partner for the life of the project, and address valuation much later, if at all. In3’s family office (In3CAP) makes an excellent Joint Venture / alliance partner in this respect, more focused on the road ahead than on near-term stock manipulation to make deals for the sake of taking their exit. This “buy and hold” approach is not fixed or immutable, just that it is better to assume a long-term partnership.

Although CAP funding is quite forgiving of most unmitigated risks that traditional investors would reject, we do expect transparent assumptions about commercial risk, at minimum, so there is a verifiable and feasible business case, boiling down to known customers — sometimes that means an “offtake” agreement with one or more creditworthy buyers, or at least market rate history with written evidence to support financial projections.

Impact Investing Metrics

Although not essential to show incentives like Investment Tax Credits, carbon credits, or non-financial “ESG” impacts such as how people benefit, the indirect value of restoring or conserving ecosystem services, eco-diversity, or numerous other measures of sustainability, it is nonetheless important to use established tools like Lifecycle Analysis to properly account for such benefits as part of the so-called Triple Bottom Line.

Each industry has its unique and often standardized metrics. For example, for power generation, investors may want to understand the Levelized Cost of Energy (more at glossary), thus showing your proficiency is a value add, even if it says more about you and your team than (by itself) conveying the true investability of your project.

Annual trended surveys of The GIIN’s impact investment community shows that 90%+ of all impact investors are increasingly obsessed with measuring and monitoring the social and environmental impacts of their investments. More at “Triple Bottom Line” in the In3 glossary.

For sustainability-related measures and standards, see either the Global Reporting Initiative, IRIS from the GIIN or the IFRS – International Sustainability Standards Board or contact In3.

Next Steps: Decide if you want to perfect your project’s Business Case and Proposal for funding or Hire a Consultant such as In3’s team of certified analysts. Here’s a 1-page “roadmap” of who typically does what