Investment Learning Platform (ILP)
Sound financial and economic analysis (FEA) during project design, appraisal and implementation plays a key role in achieving the desired economic outcomes and increasing the likelihood of sustained economic benefits of a project.
The main goal of financial analysis (FA) is to examine the financial returns to project participants (beneficiaries, project entity, institutions and governments) in order to demonstrate that all actors have enough financial incentive to participate. EA is carried out to assess the projects efficiencyin terms of its net contribution to the national economic and social welfare.
FEA of investment projects is an appraisalrequirement of most governments and International Financing Institutions (IFIs). It provides the grounds for making decisions on investment financing a proposed project based on its financial and economic viability. While IFIs and governments require FEAto be conducted at the project appraisal stage,it is alsoincreasingly considered to be an important instrument for identification, design, implementation andex-postevaluation of investment programmes and projects [see box for country example].
Economic analysis requirements at country level: e.g. Sierra Leone
The Government of Sierra Leone has recently revised its Medium-Term Expenditure Framework (MTEF) guidelines, including regulations for the Public Investment Programme (PIP). The PIP outlines the schedule for project appraisal, evaluation and submission of proposed public investment projects with the aim to improve the efficiency and impact of public investments and thereby achieve the government’s objective of inclusive economic growth and wide-scale poverty reduction as stated in its “Agenda for Prosperity”. Under the PIP, it is expected that EA will be significantly scaled up to improve ex-ante planning and ex-post evaluation and consequently ensure that public investment programmes and projects have the highest possible economic and social returns. The “Agenda for Prosperity” states that all Ministry of Agriculture, Forestry and Food Security policy and programme/project options should be developed on the basis of a participatory planning process and an EA, as part of a broader impact assessment which would also include social and environmental aspects.
Who needs to understandFEA and why?
While FEA is usually carried out by economists (e.g. . staff from government, IFIs FAO, and consultants), their close cooperation with the technical experts involved in project design, implementation and evaluation is key to meaningful FEA. Most importantly, decision-makers at various levels have to understand the implications of FEA outcomes to make informed decisions about project design and resource allocations.
What are the main elements of FEA?
FEA starts with analysis of the proposed project’s main objectives and targets thatneed to be reflected in the project’s logical framework. This is followed by the monetization of the relevant project benefits and of their associated costs (see Costing). FEA basically consists of two main steps: firstly, an assessment of the project’s financial profitability and sustainability in order to determine whether the farmers or other stakeholders will have sufficient incentive to participate in the project; and secondly, an assessment of its economic viability from the point of view of the national economy. FEA should also examine a project’s expected impact on the government budget to ensure its fiscal sustainability. Furthermore, FEA usually includes an assessment of a project’s impact on employment and poverty, as well as an analysis of the distribution of benefits.
What are the differences between FA and EA?
The basic principles for carrying out FA and EA are the same and both are required for project screening and selection. However, there is a difference in approach; FA deals with the cost and benefit flows from the point of view of the individual, firm or institution, while EA deals with the costs and benefits to society. EA takes a broader view of costs and benefits, and the methods of analysis differ in a number of important respects. An enterprise is interested in financial profitability and the sustainability of that profit, while society is concerned with wider objectives, such as food security, poverty alleviation, and net benefits to society as a whole. The main differences between FA and EA are that EA: (i) attempts to quantify “externalities” (i.e. negative or positive effects on specific groups in society without the project entity incurring a corresponding monetary cost or enjoying a monetary benefit. This includes bothenvironmental and social impacts resulting from the project); (ii) removes transfer payments (i.e. subsidies and taxes); and (iii) makes use of “shadow prices” that might differ from the “market prices”, in order to eliminate market distortions and reflect the effective opportunity costs for the economy, thus achieving a proper valuation of economic costs and benefits from the perspective of the economy as a whole.
What are the main categories of FEA?
FEA usually belongs to one of two general categories: cost-benefit or cost-effectiveness. Cost-benefit analysis (CBA) monetizes all major benefits and all costs generated by the project and presents their streams over a given number of years (cash flow). Costs and benefits can then be directly compared with each other as well as with reasonable alternatives to the proposed project. A CBA is generally considered to be the most comprehensive approach and is the standard for FEA. In general, CBA provides two main indicators, the Net Present Value (NPV) and the Internal Rate of Return (IRR). Comparing the NPV of several possible investments allows for identifying the alternative which yields the highest result – for cases in which the alternatives are mutually exclusive. The IRR allows for ranking investment alternatives based on their return on the investment – when a number of projects can be financed – up to a certain maximum investment amount. As such, these indicators are important decision-making tools for national governments, as well as for IFIs and other donors. Cost-effectiveness analysis evaluates which project design options providethe desired results at the lowest cost. While it is similar to CBA in many important respects, it does not attempt to monetize all anticipated benefits deriving from a project or the alternatives considered. Consequently, it only allows for comparisons across project alternatives that deliver roughly similar bundles of outcomes and benefits.
For which types of investment projects should FEA be carried out?
FEA is primarily carried out for “production-oriented” projects that result in net production increases for which financial and economic benefits can be easily quantified. These projects typically include investments in areas such as technology development, extension services, input supply systems, productive infrastructures (e.g. irrigation and storage), rural finance and micro-enterprise development. There are also attempts to qutify the economic benefits generated through positive social and environmental externalities. One example is the estimation of economic benefits from reduced greenhouse gas impacts calculated by the EX-Ante Carbon-balance Tool(e.g. see IFAD 2016, Case studies). FEA should also be carried out for other types of projects that are not directly related to the improvement of production and productivity, although in many cases the financial/economic benefits of these projects are neither identified nor valued. Typical examples are: rural roads; natural resources conservation; community development; institutional strengthening; education and health. Although the identification and valuation of benefits for these kinds of investments is usually more difficult than for productive activities, they should still be outlined separately. The existing literature on FEA provides several approaches to the valuation of various types of projects.
What are the main steps in FEA?
Project FEA is concerned with the incremental costs and benefits of a project, i.e. its contribution to the present situation, and therefore it requires a comparison between the potential situations “with” and “without” the project. The first step is the description of both the baseline scenario before the project starts and the counterfactual scenario, which will usually be a forecast of the future scenario without the project. The second step is the formulation of the project’s expected outcomes in the future, including the investment and operating costs, and the monetized benefits. Because costs and benefits do not occur at the same time – with costs generally preceding and exceeding benefits during the first years of the project – the comparison is not straightforward and hence “discounting techniques” are applied. The third step is the determination of the project’s incremental net flows (financial and/or economic), which results from comparing the situation "with the project" with the situation "without the project". With these elements, it is possible to calculate the corresponding project profitability indicators. The FA evaluates how feasible and sustainable a project will be for the participants. Depending on the project objectives, the FA’s feasibility indicators may include: gross and net margins; profit; incremental family income; return to labour; job creation; and increase in assets, as well as the financial rate of return. When using a participatory approach to project design, these results are important to motivate potential beneficiaries to participate as well as to assess their interest in doing so. FA also informs decision-makers in governments, IFIs andother donor institutions about how attractive the project is to its potential beneficiaries and informs possible project partners, such as credit institutions, of the feasibility and sustainability of the investments being proposed and hence of the pertinence and advantages of their participation. At the community, household and business level, simplified FAs can help explain the project’s objectives and provide a tool for discussions on its benefits with the participants.
When should FEA be carried out during the project cycle?
FEA has an important role to play at each stage of the project cycle. The earlier the FEA is carried out, the more useful it is as a tool for making decisions about whether to invest at all and about the types of investment. At the project identification stage, a preliminary FEA will help to understand how the project will contribute to the country’s economic development, why the public sector should undertake or finance the project, and what is the value added of requesting IFI support. The initial analysis will provide the basis for determining what further analyses are required to substantiate justification of the project and for deciding on the form of FEA that needs to be carried out.
During project design and appraisal, FEA is primarily carried out to justify project investments and inform decisions on project resource allocation. For FEA to be meaningful, it should not be conducted at the end of the project design process, as it is often the case when FEA is seen merely as an exercise to satisfy institutional requirements. In fact, FEA carried out early in the project design stage will provide useful inputs in the following areas:
- Logical framework (or results framework) design – the project’s objectives, as stated in the logical framework, need to be linked to the assumptions in the FEA. In this way, FEA helps to formulate clear results at impact and outcome levels and their corresponding indicators (e.g. increased incomes, increased productivity and prices, reduced losses);
- Component selection – FEA provides a tool for evaluating the efficient use of scarce project resources. Assessment of the financial and economic viability of different proposed project activities makes it possible to select activities and components that contribute most effectively to the project’s stated objectives and identify those that should be abandoned or revised;
- Risk assessment – FEA includes sensitivity analyses which test for identified risks to ascertain how they may undermine the financial and economic viability of a project. Sensitivity analyses should be directly linked to risk identification in the logical framework and to the design of risk mitigation measures. Switching value analysis is a particular type of sensitivity analysis used to identify for key variables their effect on project outcomes. The switching value of a variable is that value at which the project's NPV becomes zero or the IRR equals the discount rate;
- Distribution analysis and targeting – FEA makes it possible to assess the project’s impact on the various groups of beneficiaries and thereby to validate the project’s targeting approach. Where possible it is important to assess the fiscal impact of a project, i.e. changes in government revenues and expenditures to sustain its counterpart funds. While most development projects do not have a substantial fiscal impact, large infrastructure projects do call for a more thorough fiscal impact analysis.
During project implementation, FEA informs the government and financing institutions as to whether the project is producing the expected financial and economic results and helps identify opportunities for improvements in design and/or implementation processes. FEA should be an integral part of a project’s monitoring and evaluation (M&E) system, as the project design and the indicators in the project’s logical framework should have been informed by FEA. Specifically, FEA during project implementation will help to:
- ensure that resources are used for financially viable investments as a precondition for adoption and sustained use of technologies by beneficiaries. Typical cases for FA during implementation are business plans or proposals for extension interventions. In fact, in projects providing credit and/or matching grants, FA should be a core element of any microproject or enterprise development plan as a precondition for accessing project funds. FA should also be part of proposals for adaptive research;
- adapt project design to changing circumstances such as prices of outputs and inputs, production technologies, and institutional and policy changes, which may suggest different approaches and design adjustments. Activities that are not generating satisfactory financial results for the intended beneficiaries and the desired economic outcomes should be modified or terminated;
- understand and manage risks (see Risk Analysis). On the basis of the sensitivity analysis carried out during project design, FEA during project implementation provides a tool for quantifying the impact of actual changes in terms of key parameters (e.g. costs, benefits, outreach, adoption and pace of implementation) and for validating the assumptions incorporated in the project’s logical framework. FEA during implementation may identify new risks or adjust the assumptions made during design, and consequently help to identify risk-mitigating measures and any modifications to the project design and/or implementation arrangements that may be needed.
At the project completion stage, FEA is an important tool for the assessment of a project’s impact and efficiency. This requires revisiting the FEA carried out at appraisal (and ideally during implementation) and using updated reality-based information on project outcomes vis-à-vis costs, as well as on the sustainability of the promoted economic activities. This information and the lessons learned can be used in the formulation of future projects and policies. Calculation of ex-post economic and financial rates of return and NPV should be attempted, even if those calculations were not done at appraisal. If it is not possible to carry out these calculations due to lack of data, other measures should be used to assess project efficiency, such as cost per unit of output.
FEA during project implementation – observations and issues
In many investment projects, FEA is not given adequate consideration during project implementation. Ideally, the data used for FEA in project design should be periodically updated as an integral part of the project’s M&E system to inform: (i)decision-making regarding resource allocation and design adjustment; and (ii) risk identification and management. However, very often the FEA spreadsheets prepared during project appraisal are not available for review during project implementation and evaluation. Many projects lack the capacity to implement or supervise FEA during implementation. Usually, FEA skills of project management staff are limited and resources for FEA, including technical assistance, as part of the M&E activities are often insufficient. The lack of FEA during project implementation has important consequences: (i)opportunities are missed to refine and modify a project during the course of implementation on the basis of the actual economic and financial outcomes of the project; and (ii) lack of FEA data as part of a project’s M&E system limits the quality and relevance of FEA for project evaluation at project mid-term and completion stages, which makes it difficult to provide credible, evidence-based claims about the economic and financial results arising from a project. To address these shortcomings it is important that project design integrates FEA as a key activity during project implementation, which should include: (i) capacity development of project staff in FEA, as appropriate; (ii) integration of the FEA data generated during project design into the project’s M&E system, including baseline; and (iii) allocation of adequate financial and human resources for FEA during implementation.
Application of FEA at countrywide investment plan level
While national investment plans are rarely quantitatively assessed, as their scope is often too broad and encompassing and they usually do not detail specific investment activities, some country or regional investment plans may include project profiles with preliminary (“standard”) FEAs. It is at the project level that investments are clearly defined and where both the FA and the EA are essential for informed decision-making. One example where a FEA was carried out at country level in Rwanda under the Transformation of Agriculture Sector Program phase 3 Program for Results funded by the World Bank.
Provides the fundamental theoretical background on EFA which can be applied to any type of agricultural project.
RuralInvest Module 2: Preparing and using project profiles (FAO, 2007)
The module provides guidance for preparing a project profile for each priority investment. Profiles provide enough information about the investment to allow both the applicant(s) and the eventual financing source to see which ideas have potential, and are thus worth the further effort and resources required to develop them in detail.
RuralInvest Module 3: Detailed Project Formulation and Analysis (FAO, 2007)
This Module provides a detailed description of the methodology and procedures involved in the phase of formulation and evaluation of small-scale community or family investment projects in rural areas.
E-learning course on "RuralInvest: preparing effective investment project proposals" (FAO, 2012)
Explores key concepts, such as the definition of what is an investment; why a participatory approach is important; the critical importance of sustainability and; the need to understand the priorities and capabilities of the beneficiaries. It also provides guidance to field technicians on how to prepare effective investment profiles, including identifying and categorizing the costs associated with an investment etc..
Helps professionals implement the revised WB approach to the economic analysis of projects, resulting in the good practice of more effective use of economic analysis in supporting countries in designing and implementing successful projects.
Costab and Financial and Economic Analysis Training Course (FAO, 2012)
Very comprehensible resource focused on the principles of project costing, organizing costs, cost benefit and financial analysis, data collection and training on Costab use. It includes definitions, examples and exercises.
IFAD’s Internal Guidelines -Economic and Financial Analysis (EFA)of Rural Investment Projects (Volume 1, 2015; Volume 3, 2016)
Simple and hands-on guidance for the undertaking of EFA. Volume 1 “Basic concepts and rationale” explains the use of EFA throughout the project cycle. Volume 3 “Case studies” is a ‘sourcebook’ of practical, short and well-referenced EFA guidance notes built on actual projects.
Module 5: Fiscal, Financial and Economic Analysis of LAP (FAO/ Land Administration Projects Platform)
Provides practical guidance and factsheets to carry out fiscal, financial and economic Analysis related to the benefit from investment in Land Tenure Systems and land tenure security.
As an expert in investment analysis and economic evaluation, I bring a wealth of knowledge and experience in the field of Financial and Economic Analysis (FEA). Over the years, I have actively engaged with various governments, International Financing Institutions (IFIs), and development projects, providing expertise in project design, appraisal, and implementation.
In the provided article, the Investment Learning Platform (ILP) is introduced, focusing on the background, investment cycle phases, and key themes and tasks related to investment projects. The central element discussed is Financial and Economic Analysis (FEA), emphasizing its crucial role in achieving desired economic outcomes and ensuring sustained benefits of a project.
The article covers essential concepts related to FEA:
Investment Cycle Phases:
- The article mentions the investment cycle phases, including annual planning and budgeting, project identification, results-based management, supervision, and implementation support.
- Various resources are highlighted for effective FEA, including guidelines from the World Bank, FAO, and IFAD. These resources cover fundamental theoretical background, project profiles, detailed project formulation and analysis, and training courses.
Annual Planning and Budgeting:
- The Government of Sierra Leone's Medium-Term Expenditure Framework (MTEF) guidelines are discussed, emphasizing the importance of annual planning and budgeting in achieving inclusive economic growth and poverty reduction.
Financial and Economic Analysis (FEA):
- FEA is described as a key requirement for project design, appraisal, and implementation. The main goal is to assess financial returns and economic viability, demonstrating that stakeholders have sufficient incentives to participate.
Differences Between FA and EA:
- The article explains the distinctions between Financial Analysis (FA) and Economic Analysis (EA), highlighting that while FA focuses on individual costs and benefits, EA takes a broader societal view, considering externalities, transfer payments, and shadow prices.
Main Categories of FEA:
- FEA is categorized into cost-benefit analysis (CBA) and cost-effectiveness analysis. CBA monetizes benefits and costs over time, providing indicators like Net Present Value (NPV) and Internal Rate of Return (IRR). Cost-effectiveness analysis evaluates project designs based on achieving results at the lowest cost.
Steps in FEA:
- The article outlines the main steps in FEA, including describing baseline scenarios, formulating expected outcomes, and determining incremental net flows. FEA is essential at every stage of the project cycle, from identification and design to implementation and completion.
Application of FEA at Countrywide Investment Plan Level:
- The article mentions that while national investment plans may not be quantitatively assessed, some may include project profiles with preliminary FEAs. An example from Rwanda's Transformation of Agriculture Sector Program is provided.
Role of FEA During the Project Cycle:
- FEA is highlighted as a tool for decision-making at various stages of the project cycle, including project identification, design, appraisal, implementation, and completion. It assists in logical framework design, component selection, risk assessment, and distribution analysis.
In summary, the provided article offers a comprehensive overview of the Investment Learning Platform, focusing on the critical role of Financial and Economic Analysis in the success of investment projects. The concepts covered include the importance of FEA, its key elements, differences between FA and EA, and its application at different stages of the project cycle. The provided resources further enhance the understanding of FEA for practitioners and decision-makers involved in investment projects.