“What’s the difference between a financial and economic analysis?”
This question was posed during a presentation in which I was using both terms. It’s a good question and the distinction is important. Both are concerned with benefits and costs; and, both compare net benefits for scenarios with the project to scenarios without it. But the perspective of the analysis is different in each case, which alters the ways in which benefits and costs are counted.
The main distinction is that an economic analysis compares costs and benefits accruing to the entire economy, while the financial analysis makes that comparison from the perspective of an enterprise.
In a financial analysis, the viability of the project is based on its financial profitability – what remains from the revenues after all the bills are paid. Since the enterprise has owners, who are providing equity, a financial analysis seeks to identify the return on equity the project can provide. Benefits, therefore, are the year-on-year cash inflows received by the enterprise, in the market. For example, an electricity project would measure benefits as anticipated revenues from electricity sales (inflows). Costs are financial outflows. For a financial analysis these are called direct costs, and are reflected in market prices for debt financing, engineering, construction, inputs, operations, maintenance, etc. They are allocated to appropriate time periods of the project lifecycle and usually discounted at a weighted average cost of capital. Discount rates can also be nuanced to reflect differing risks for different stages of development. Before a capital structure has been formed, the financial analysis can be a market study that determines whether the enterprise’s services are price competitive. During later stage development, the financial analysis takes the perspective of a special purpose vehicle (SPV), for which a three-statement proforma model can be developed.
By contrast, an economic analysis considers the broader perspective of the public sector. Benefits in this case, are all social and economic benefits that accrue to the public welfare. These might include the avoided costs of less optimal project alternatives. They may also include health and public-use benefits, long-range climate benefits, and other advantages. For example, one benefit of a renewable energy facility is the avoided use of fuel. Therefore, a portion of the project benefits would be the cost of avoided fuel for a traditional energy source (i.e. fuel for gas-powered plant that will not be built). Additional benefits would include power capacity, avoided carbon output, etc. Costs are also different from a financial analysis; they consider what the project would cost monetarily, but also any additional burdens the project would impose on society.
For both benefits and costs, economic prices are used in place of market prices. The difference between economic and financial prices arise from two sources. First, financial prices are often subject to price distortions such as transfer payments, price controls, monopolistic pricing, etc. These contain elements that are paid or received by the firm but do not affect economic prices. Second, non-market effects are outputs or inputs that are not captured in the marketplace such as positive or negative externalities.
Finally, an economic analysis can also be a qualitative assessment if data for a quantitative study are not available. Often some type of proxy data can be found, but sometimes this is not the case. Furthermore, a quantitative assessment is not always required by the situation.
For a comprehensive view, the Asian Development Bank provides Guidelines for the Economic Analysis of Projects, one of the best resources on this topic.
Richard Swanson, Ph.D.
Asset valuation and project finance expert, specializing in financial and economic analysis of civil infrastructure assets.