15

PROJECT FINANCIAL MANAGEMENT

Project Financial Management determines how the project will be financed, including the processes to acquire and manage the financial resources for the project. It is more concerned with revenue sources and monitoring net cash flows for the construction project than with managing day-to-day costs. While construction professionals are skilled in the technical side of their work, they often lack financial management knowledge and understanding. Research has shown that project managers in construction need to know financial management fundamentals in order to better understand and navigate the financial decisions that are part of every construction project. This section presents important considerations on financial management relative to privately funded construction projects. Government or public construction funding may vary by the country and jurisdiction where the financial solution is being considered.

15.1Project Financial Management in Construction

Financing of construction projects may be considered from different perspectives: the owner's perspective with due considerations for its interaction with other organizations involved in the project, or from the construction contractor's perspective. The owner of the construction project may belong to the public or private sector; construction projects may be small- to medium-size, large, or megaprojects; and the type of financing may have long- or short-term effects. Each of these aspects impacts financing arrangements and construction project finance solutions adopted for the project.

Within the organization, financial management is concerned with the efficient and effective management of funds in such a manner as to achieve organizational objectives. Financial management includes the planning, monitoring, and controlling of the financial monetary resources of the organization and is one of the main functional areas directly associated with the top management.

In traditional construction projects, the owner typically pays for the cost of the project by means of periodic (usually monthly) progress payments. In this scenario, the contractor finances the initial costs of set-up and possibly a couple of initial months of work. Many contractors are able to undertake these expenses or obtain a short-term loan to cover this initial period. In other cases, the owner or sponsor provides initial working capital by paying the contractor an initial advance, which represents a percentage of the approved budget that is discounted at the same rate in monthly take-offs. The details of this arrangement are stated in the contract.

More recently, however, the construction industry is facing increasing requirements to finance the entire project as a result of the use of different types of project delivery methods (BOT, DBOO, DBOM, etc.) and public-private partnership (PPP) project financing. This trend mandates the contractor, who often leads a consortium, be conversant with and knowledgeable about the subject and general financial management techniques.

Financial management is distinctly different from cost management, which relates more to managing the day-to-day costs of the project for labor and materials. In this section, the discussion is limited to financing the cost of the construction project itself, although long-term financing may include both construction and operation, such is the case in PPP projects.

It should be noted that through the construction project's life cycle, the project manager's responsibilities for financial management may be broken down into four broad areas: accounting for financial resources of the project, managing costs and profits, managing cash flows, and making financial decisions or providing the necessary verified information to the project sponsor for making such decisions.

Financial management introduces additional stakeholders such as management accountants, certified public accountants (CPAs), certified financial analysts® (CFA®) charter holders, sureties, insurance firms, banks, project investors, management consultants, etc.

15.2Project Financial Management Planning

Project financial management planning is the initial phase of financial management of construction projects that identifies and provides all financial requirements for the project and assigns project roles and responsibilities, reporting relationships, etc., for the project. Financial planning is no different from standard project planning: tasks are identified, and requirements are quantified and placed on a time scale. Resources are also required to ensure that the financial tasks are completed on time.

15.2.1Sources of Funds for Construction Projects

The funds for a traditional project are often obtained from a company's central financing system, which may be a combination of borrowing from financial institutions, retained profits, and financial reserves. The financing costs are normally charged as interest to the project's cost account for construction projects.

In the institutional sector, funds frequently come from donors, through government, or from other grants. Government funding is secured through a process that requires project applicants to provide comprehensive documentation. Critical input is reviewed to:

• Verify definition and clarify scope, schedule, and budget;
• Assess project objectives and benefits;
• Justify the return on investment;
• Establish correlation to business strategic plans;
• Validate the ability to perform effective project management; and
• Determine realistic milestones to meet schedule dates and asset goals.

Competition for funding can be significant. Obtaining contracts will depend on the quality of applications, as well as the applicant's record of completing projects within parameters and in demonstrating the usefulness of the asset.

For privately funded projects, there are many possible sources, such as commercial paper backed by a bank or credit facility, bank loans, public debt offerings, private placements in the U.S. and international markets, syndicated commercial long-term loans, government entity loans, etc. In some cases, funding may occur incrementally in different phases of the project. The financial plan and the overall project plan should consider the funding milestones of the project in order to maintain the momentum and the continuation of the project. Final determination of funding sources depends in large part on the project's creditworthiness and project sensitivity to changes in interest rates. In almost all of these types of projects, the participants acquire some equity in the project.

On project-financed projects (see Section 15.2.5, Construction Project Finance and Corporate Finance), an initial investment is required before being able to draw a loan. Costs for the initial study of the project from the feasibility analysis to the final development of the business and financial planning, which are submitted to eventual lenders, are usually covered by company/owner equity.

Finance techniques may differ by country or region, type of project, owner, and total funding sought. Nevertheless, the following are some of the most commonly used finance techniques in privately funded construction projects in the global construction industry:

• Traditional. Projects have traditionally relied upon well-known project finance techniques, such as funding by the owner organization's existing funds, and equity or debt made available by commercial banks.
  • Senior debt. Senior debt refers to debt that is in first-lien position. In cases of default, senior lenders have priority in recouping their investment.
  • Construction loan. Construction loan is debt granted to the owner to finance the project construction.
• Subordinated debt. A subordinated debt is a loan or security that is not reimbursed in instances of default until senior debt holders are paid in full.
• Mezzanine financing. Mezzanine financing takes the form of subordinated loans as a short-term project financing solution that is paid back after the senior debt. For example, real estate developers draw upon mezzanine loans for supplementary financing development projects.
• Asset backed securitization (ABS) financing. This financing method collects funds for the construction of the project by means of issuing bonds and asset-backed securities in the finance market, using the future cash flow the project can generate as a guarantee.
• Project finance bonds. A project bond issued by a company is a debt tradable document where the issuer (in this case, the organization executing the project) agrees to repay the bondholder the amount of the bond plus interest on fixed future installments dates.
• Miscellaneous financing methods. Other types of financing methods involving bond issuance as a means to fund state capital projects are general obligation bonds, revenue bonds, and certificates of participation.
• Project leasing. The organization performing the project may lease vehicles and equipment as a way of raising finance. A land or facility may also be leased as an alternative to the acquisition.
• Contractual (vendors/contractors finance). A contractor, subcontractor, or equipment and materials supplier may offer finance as part of the bid (as a way to secure the contract). For example, an equipment supplier may be willing to take the financial risk of offering a loan (selling on credit) or a lease of equipment as a way to increase sales or open up to new markets.
• Preconstruction sales in real estate construction projects. For-sale real estate construction project developers may sell properties prior to construction in order to financially secure their project. In such cases, lenders may require a percentage of the project be pre-sold in order to approve the construction loan.
• Factoring. Sometimes a business may find immediate short-term financing by selling its receivables (e.g., invoices) to a specialized third party entity known as a “factor” (usually a bank or factoring company) that charges a commission.
• Other possible sources of funds. Project funding may also be found in commercial paper backed by a bank, credit agency, or multilateral development bank; public debt offerings; private placements in the local and international markets; and subsidies.

15.2.2Short-Term Financial Fluctuations

The construction progress of work may experience shortfalls in financial resources or cash flow both from the owner's and contractor's perspectives. In some cases, the following informal methods are used to confront these short-term financial fluctuations in the construction industry:

• Overdraft facilities. Banks may permit withdrawals from a company bank account in amounts exceeding the available funds. Usually the withdrawal period, maximum amount, financial cost, etc., are previously agreed upon with the bank.
• Lines of credit. A line of credit consists of an agreed-upon amount of money available on an as-needed basis to be borrowed at any given time at a variable interest rate usually accrued monthly.
• Payment delays. In some cases, the owner will shift financing expenses to other parties of the project (contractor, subcontractor, suppliers, etc.) to overcome momentary shortfalls in financial resources.
• Cost in excess of billings (underbilling) and billings in excess of costs (overbilling). This accounting concept linked with the construction progress of work and invoicing may create cash flow shortfalls. In such cases, the owner may advance amounts to contractors looking for a gain in lower financing costs shared by both parties through prior agreement.
• Owner resources. Owners that manage recurring programs of capital projects, such as government agencies, may provide additional funding from reserve accounts to ensure projects with forecast cost overruns can be completed.

15.2.3Economic Environment

The economic environment is an external factor that is outside the project manager's control. Despite this, the project manager should be aware of all risks emerging from the economic environment and should ensure that the financial plan is updated periodically to allow for them. Factors may include political, regulatory, social, and economic issues such as country risk, currency fluctuations, labor relations, changes in legislation, etc., which can increase or decrease the cost of the project.

15.2.4Analytical Techniques, Feasibility Study, and Sensitivity Analysis

For long-term projects financed by the contractor, a study should be conducted to determine if the project could be profitable within the given parameters.

Cash flow measurement is a prime way of determining the viability of a project. Construction projects rely on cash inflow to balance the costs incurred in order to keep financing costs to a minimum. A good practice is to perform a sensitivity analysis—a what-if analysis of projected performance—to assess alternatives based on changing one variable at a time to observe the result. In finance, especially as associated with net present value (NPV) and internal rate of return (IRR), this term has a specific meaning and is also commonly used in projects.

It should be noted that cash inflow predictions are often hampered by the valuation of work in progress. At any given time, the project under execution will have uncompleted work packages not yet invoiced. The valuation of this work, or work in progress, should be performed in a consistent fashion for each project and across all construction contracts for the organization.

15.2.5Construction Project Finance and Corporate Finance

Alternatives may be used for the financial planning of a construction project, namely, corporate financing by means of the company balance sheet or project financing by incorporating the project into a new legal and economic entity created ad hoc.

Corporate finance uses the company assets and cash flows to guarantee the construction loan, while project finance is the structured financing of a specific project using equity or mezzanine debt. With project financing, the various stakeholders seek an equitable allocation of the project's risks. The project financing solution is much more costly than corporate financing as it implies higher lenders’ risks transferred as higher financial costs, additional legal and insurance contract complexity, and greater costs of monitoring the project progress.

At a corporate level, financing is usually performed using a mix of corporate debt (bonds and notes) and existing funds. Individual projects may not be considered at the corporate finance level and may involve different financing arrangements. For example, performing project financing in large infrastructure projects consists of the equitable allocation of a project's risks among project stakeholders. Thus, in project financing, those stakeholders who provide the senior debt place a substantial degree of reliance on the performance of the project itself.

15.2.6Legal Entity

Defining the most appropriate and advantageous legal form of the venture depends on internal and external factors of the business, namely, type of project, type of organizations involved, risk and liability allocation, and bankability. Partnership, corporation, trust, joint venture, or combinations thereof are special purpose vehicles (SPVs) currently used as the legal form of the specific economic entity that performs the project.

SPVs are legal entities created for a special financial limited purpose: acquiring and/or financing of a construction project and/or operation. SPVs are specific and unique to each project, depending on the legal and financial agreements between stakeholders and type of project. SPVs are complex contractual arrangements where a number of different parties with different objectives find an appropriate manner to fulfill their needs. An SPV is used to raise funds under cheaper conditions by means of a sophisticated financial structure separate from the parent company's balance sheet.

15.2.7Contract Requirements

For contractor-financed projects, the contract may contain important clauses that restrict the contractor's ability to obtain favorable terms. Since this type of project is often awarded after a proposal process, there may be an opportunity for the contractor to negotiate more favorable terms.

The contract and the project plan help define requirements for the financing needs of construction projects. The contractual terms of payment from the client are an input in ascertaining the financial needs of a project to help estimate the cash flow, which influences the project finances.

15.2.8Financial Impact Risk Factors

A proper financial plan allocates risks among participants, investors, customers, and interested third parties. Some of the risks that influence obtaining favorable financing are completion risk; cost overruns; and regulatory, political, and technology risks (see Section 11 on Project Risk Management). Further, it is not uncommon for a financial and insurance institution to ask for a complete risk analysis of the project's potential environmental impacts in order to ensure that funds will be adequately applied to minimizing impacts due to the project environment.

15.2.9Tax Planning as a Financial Factor

An important factor to consider in the financial planning of the project is that in many countries interest is tax deductible while dividends to shareholders are not; this factor encourages financial leverage over the use of equity.

Many long-term major projects may provide tax benefits that should be accounted for while working on the project's financial plan.

In some countries, lease finance or leasing, as discussed in Section 15.2.1, provides tax benefits. A study on the advantages of tax depreciation and other taxable revenues may be needed to create the most efficient taxation structure for the project.

15.3Project Financial Management Monitoring and Control

Financial control ensures that bonds are reduced when necessary, calls for funds from project partners are made as needed, and all insurance and bank withdrawals/deposits are performed at the appropriate times. Financial control and cost control should be executed effectively to ensure all items are within budget and the financial cash forecast. Effective project financial monitoring and control is better achieved when a project produces regular progress reports.

15.3.1Project Accounting Systems

The project accounting system should be similar in structure to the WBS, showing the breakdown of the total project in more controllable modules. As stated in Section 7.2.7.2, a cost breakdown structure (CBS) is sometimes developed as a mapping tool between the WBS and COA to aid in reporting costs. A CBS links cost activities in an estimate to the COA. A WBS is project-specific while a CBS is organization-specific.

On small- to medium-size projects, the breakdowns can be kept on simple spreadsheet-generated S-curves. Accounting systems are usually more sophisticated for large projects. Financial control is exercised by closely monitoring actual spending and revenue against budget and cash flow forecasts, adjusting either the work methods or problem areas where this mechanism shows deviations. It is imperative to keep proper financial records, including records of income, expenses, and all other financial transactions for the project. It is good practice for the project manager to check that all financial information is recorded and reported appropriately.

15.3.2Financial Internal and External Audits

Internal and/or external audits ensure correct accounting methods and financial practices are being maintained. These audits are often helpful to the project manager in uncovering otherwise unseen problems. External audits are often a statutory requirement of the local government or are mandatory under the financing conditions arranged with lenders.

These audits focus primarily on the basic financial statements of the project, such as statement of income or revenue and expense accounts, statement of retained earnings, statement of cash flows, work-in-progress schedule, supplemental schedules, contact retention status, etc. Periodic financial audit reports may also contain warnings of over investment on fixed assets, poor credit arrangements, and improper use of project funds.

15.3.3Cash Flow Analysis

Regularly updating all of the actual financial and cost data provides an up-to-date financial information system from which the project manager analyzes trends based on unique characteristics of the project. From these trends and past actual data, the project manager can revise the forecast for the remaining duration. Poor inventory and cash flow management may seriously hamper construction project success.

15.3.4Financial Reports

For projects that need full financing, management and any lenders involved require periodic financial reports. When projects comprise some form of consortium or partnership, periodic (often monthly or quarterly) meetings are typical, during which project leaders present the status of the project and forecast its future, including the state of its financial health.

Cost and financial reporting in construction projects has different purposes: internal reporting to managers for day-to-day cost planning, monitoring, and control (progress and performance reports); internal reporting to managers to support strategic planning (financial reports); external reporting to owners and other parties on a partnership arrangement; and external reporting to financial institutions fulfilling financial agreement reporting covenants.

15.3.5Professional Expertise: Project Monitor, Lender's Engineer, Investor's Engineer, or Technical Advisor

The use of professional expertise such as accountants, legal advisors, insurance and investment brokers, or others who will advise on issues related to monetary policies, investor relations, the stock market, wills, trusts, funds, etc., may add considerable value toward avoiding financial pains.

Project monitors, the project's design architects and engineers, lender's engineers, or investor's engineers verify the physical status of work throughout the construction stage and periodically report the quantum of finance actually being contributed and used on the project to ensure against misuse of funds.

15.3.6Ex-Post Evaluations

Ex-post evaluations are methodologies to assess the effectiveness of the project and the aims fulfillment. The result compares the proposed benefit and the achieved benefit, such as net cash flow, IRR, fee, and others’ financing parameters.