When a business has the expertise and resources to undertake a
contract but lacks the funds to complete it, the lack of funding
may cost it the contract. The term contract financing refers to
how a business can receive advance funding on an awarded
contract it is yet to complete.
Most commercial contracts in the construction industry are paid
for in milestones throughout the process or fully at the end of
contract completion. In either case, business owners will need to
invest their own money to prepare and execute the specific
project.
For instance, the business will need to source funds for initial
tasks such as data analysis and sourcing materials and tools. If a
company cannot raise the funds it needs to execute or complete a
contract, the client may even cancel the entire contract and
choose to go with a competitor.
What Is Contractor Financing?
Contract financing is an excellent way for a business to access
business loans against a contract which it has already won. In
such a case, the lender will consider the creditworthiness of the
client and not the business’s when considering the funding
request.
Before funding the contract, the lender may analyze the terms of
the contract and especially payment milestones and timelines as
well as the contract price. Contract financing differs from
traditional bank loans in many ways. It is underwritten based on
the terms of a contract the business has already signed and the
creditworthiness of the client rather than the borrower’s assets or
credit record.
Contract financing is available to a business that has already won
a client contract and is ready to fulfill it once funds are available.
In some cases, the process of seeking contract financing may
begin long before the contract is awarded.
A good example of such a situation is when the client demands
proof of funds to meet the project’s costs before the business is
awarded the contract.
Clients seeking high-value or time-sensitive services may insist
that the business provides proof of funding before awarding the
contract. This demand is often required to assure the lender that
the project will be completed and not delayed or stalled due to a
lack of funds.
In such a case, the business may request the lender to issue a
‘letter of intent to fund’ to enable the business to win the
contract. As the name implies, this letter lets the client know that
the contract financing lender is prepared to advance funds to the
business should it win the contract.
Before the lender issues the letter of intent to fund the project,
they may demand business documents and details of the
contract. Lenders often require such documents as the business’s
profile, financial statements, and reference letters from previous
clients. These documents help the lender assess the business’s
credibility, resources, and capacity to fulfill the client contract.
How Contract Financing Works
Contract financing is different from a traditional business loan in
many ways. For starters, it is an unsecured loan, hence riskier
than the conventional secured loan. Because of this, the lender
may take extra precautions and look at more factors than they
traditionally would before approving a business loan. Here are the
three most notable factors that a lender will consider when
evaluating a business for a contract loan.
Monthly Billing
The amount of money a lender can advance a business will
largely depend on the borrower’s average monthly billing. This
does not refer to the average amount the business pays in bills
per month; rather, it refers to how much the company receives
from its customers in a month.
The lender will want to know that the business’s monthly income
is sufficient to cover the loan amount should the project client fail
to pay.
While the client’s contract is the collateral in this loan, the lender
will want to know that the business can cover the amount in a
reasonable time even without the contract milestones or
completion payments.
Time in Business
The duration in which the business has been in operation is one
of the most critical factors for contract financing. New businesses
are riskier than businesses with deep roots in their market; hence
lenders will be reluctant to loan them.
Most contract financing lenders will only consider businesses that
have been in operation for at least six months to a year.
However, the minimum operation period may vary depending on
the lender and their lending cap and the borrower’s industry.
Credit Rating of the Customer
A lender will scrutinize the creditworthiness of the contract client
before approving a loan because it is the client that pays the
loan. The lender will look at the client’s credit history, business
rating, and other factors before deciding whether to approve the
funding.
Often, the financier may advance the business as much as 90%
of the contract invoice amount, especially in a government
contract financing. It will want to know that the customer is good
for the money and will make invoice payments as per the
contract details without fail.
Types of Contract Financing
Contract financing can be categorized based on how the project
funds are monitored and controlled. Most lenders will put
measures in place to track and even control the contract
payments and expenses. The more established the borrower, the
less the lender will feel the need to manage the finances.
Here are the three types of contract financing options available to
a business:
1. Lender-Controlled Contract Financing
In this form of contract financing, the lender deposits the
borrowed funds into an account separate from the borrower’s
main account as per the contract terms. The lender will monitor
the movement of money in and out of the account throughout the
load duration. When the contract is completed and all payments
made, the lender will deduct charges from the account, transfer
the funds to the borrower’s account, then close the loan account.
2. Borrower-Controlled Contract Financing
In this form of contract financing, the borrower is in full control of
the contract as well as its finances. The funds may be deposited
into the contract account as a short-term loan or an overdraft.
While the loan may be used at the borrower’s discretion, the
lender will often monitor account transactions to ensure the funds
are responsibly managed and used for the contract only. The
lender may charge interest every month from the loan account
and the entire amount at the fulfillment of the contract.
3. Purchase Order Contract Financing
This contract loan caters to purchasing raw materials, inputs,
labor, packaging, service or product delivery, or other costs of
fulfilling the contract. With this contract financing type, the lender
may make direct payments to suppliers and service providers
rather than advance cash to the business. Because of its low risk,
this is a popular form of financing for new businesses or
companies with a less-than-excellent credit score.
Where to Get Contract Financing
Because contract financing is technically not a loan, banks
generally do not get involved in it. Instead, private firms such as
Billd that deal with factoring are often the go-to lenders for this
type of funding. Most of these firms operate or can be found
online and often offer different packages of the same type of
funding.
A business seeking contract finding may need to choose from
contract financing, accounts receivable factoring, and invoice
factoring. These firms are not as tightly controlled as banks;
hence, borrowers must take the time to understand the finer
details of contract financing offers before committing their
businesses to a funding offer.
FAQs About Contractor Financing
What is contract finance?
Contract finance is a form of funding that allows a business to
receive short-term loans or capital finance to undertake a
tendered contract.
Can you borrow money against a contract?
Yes. While the contract is the collateral for the loan, lenders will
often demand proof of capacity to cover the loan should the
contract fall through.
What does a contract financing payment mean?
This is an authorized disbursement of funds to a business before
the contract is completed.
How can you finance a government contract?
There are various ways your business can finance a government
contract, including invoice financing, purchase order financing,
supplier financing, accounts receivable refactoring, or asset-based
lending.
Do government contracts pay upfront?
It is not unusual for the government to pay a certain percentage
of a project cost up-front. However, most government contracts
detail the terms of payments to help businesses secure funding
from other sources. Typically, the final payment is paid upon
successful completion of the contract.
Project selection criteria are typically classified as:
A. Financial and non-financial
B. Short-term and long-term
C. Strategic and tactical
D. Required and optional
E. Cost and schedule
Which of the following financial models are typically included in project selection?
A. Payback
B. Net present value
C. Internal rate of return
‘
D. Both A and B are correct
E. A, B, and C are all correct
Projects are usually classified into all but one of the following categories. Which one is
not one of the typical classifications?
A. Compliance and emergency
B. Operational
C. Strategic
What is Project Management Life Cycle?
A Project Management life cycle is a five-step framework planned to assist
project managers in completing projects successfully.
The primary competency of a project manager is to gain a thorough
understanding of project management stages. Knowledge and planning for
the five Project Management steps will help you plan and organize your
projects so that it goes off without any hitches.
It is simpler for a project manager to handle all the current details of the
project when the project is broken down into various phases. Each phase of
the cycle is goal-oriented having its own set of characteristics and contains
product deliverables, which are reviewed at the end of the Project
Management steps.
According to the Project Management Book of Knowledge (PMBOK), the
Project Management life cycle should define the following aspects:
•
What work needs to be achieved?
•
Who will be involved in the team?
•
What are the project deliverables?
•
How to monitor the performance of each phase?
Phase-to-Phase Relationships
In cases where projects have two or more phases, the phases are considered
part of a sequential process. However, in some situations, the project might
benefit
from
overlapping
or
concurrent
phases. The
phase-to-phase
relationships can be of two types:
•
Sequential
Relationship
In a sequential relationship, a new phase starts only when the
preceding phase is complete. The step-by-step nature of this
approach decreases uncertainty, but may also remove options for
reducing the overall schedule.
•
Overlapping
Relationship
In an overlapping relationship, as the name suggests, the next phase
starts before the completion of the previous one. Overlapping phases
sometimes need additional resources because work has to be done
in parallel. It may increase risk or could lead to rework if a succeeding
phase progresses before correct information is gathered from the
previous phase.
Predictive Life Cycles
In predictive life cycles, also known as fully plan-driven the three major
constraints of the project, the scope, time, and cost, are determined early in
the project life cycle. These projects progress through a series of sequential or
overlapping phases. Now the planning can be done for the entire project at a
detailed level from the beginning of the project. Different work is usually
performed in each phase. Therefore, the composition and skills required of the
project team may vary from phase to phase.
Adaptive Life Cycles
The adaptive life cycles, also known as change-driven or agile methods, are
used in cases of high levels of change or application areas such as IT. Adaptive
methods are also iterative and incremental, but the difference is that
iterations are very rapid (typically with a duration of 2 to 4 weeks) and are
fixed in time and cost. Sometimes the processes within the iterations can be
going on in parallel.
5 Phases of Project Management Life
Cycle
1. Project Initiation
Project initiation is the first Project Management life cycle phase, where the
project starts. It provides an overview of the project, along with the strategies
required to attain desired results. It is the phase where the feasibility and
business value of the project are determined.
The project manager kicks off a meeting to understand the client and
stakeholders’ requirements, goals, and objectives. It is essential to go into
minute details to have a better understanding of the project. Upon making a
final decision to proceed, the project can move on to the next step: that is,
assembling a project team.
The Project Charter is considered to be the most important document of any
project as it comprises:
•
Business vision and mission
•
Project goals and benefits
•
List of stakeholders
•
Scope of the Project
•
Project deliverables
•
Risks associated with the project
•
Project budget and resources
A. Undertake a Feasibility Study
In the initial stage, it is essential to understand the feasibility of the project.
See if the project is viable from the economic, legal, operational, and technical
aspects. Identifying problems will help you analyze whether you can solve
issues with appropriate solutions.
B. Identify the Project Scope
Identifying the project scope involves defining the length, breadth, and depth
of the project. On the other hand, it’s equally essential to outline functions,
deadlines, tasks, features, and services.
C. Identify the Project Deliverable
Upon identifying the project scope, the very next step is to outline the project
deliverables. The project deliverables include defining the product or services
needed.
D. Identification of Project Stakeholders
A thorough identification of project stakeholders is essential. It is better to
have meetings with team members and experts to identify project
stakeholders. Documentation of relevant information on stakeholders and
impact on them on successful completion of the project is required.
E. Develop a Business Case
Before developing a business case, check whether the essential pillars of the
project such as feasibility, scope, and identification of stakeholders are in
place. The very next step is to come up with a full-fledged business case.
Creation of a statement of work (SoW) and the formation of a team wrap up
the project initiation phase.
2. Project Planning
A lot of planning related to the project takes place during this phase. On
defining project objectives, it is time to develop a project plan for everyone to
follow.
The planning phase frames a set of plans which help to guide your team
through the implementation phase and closing phase. The program created
at this point will surely help you to manage cost, quality, risk, changes, and
time.
The project plan developed should include all the essential details related to
the project goals and objectives and should also detail how to achieve them. It
is the most complex phase in which project managers take care of
operational requirements, design limitations, and functional requirements.
The project planning phase includes the following components:
A. Creating a Project Plan
A project plan is a blueprint of the entire project. A well-designed project plan
should determine the list of activities, the time frame, dependencies,
constraints involved, and potential risks. It assists the project manager to
streamline operations to meet the end objective and track progress by taking
appropriate decisions at the right time.
B. Creating a Resource Plan
The resource plan provides information about various resource levels required
to accomplish a project. A well-documented plan specifies the labor and
materials to complete a project. Resources used should have relevant Project
Management expertise. Experience in the concerned domain is a priority.
C. Budget Estimation
Framing a financial plan helps you to set the budget and deliver project
deliverables without exceeding it. The final budget plan lists expenses on
material, labor, and equipment. Creating a budget plan will help the team and
the project managers to monitor and control the costs throughout the Project
Management life cycle.
D. Gathering Resources
Gathering resources is an essential part of project planning as it helps to
monitor the quality level of the project. It is not enough to assemble a wellbalanced team from internal and external resources. Resources like
equipment, money, software solutions, and the workplace should be given to
complete the assigned tasks.
E. Anticipating Risks and Potential Quality Roadblocks
The risk plan will help you identify risks and mitigate them. It will comprise all
the potential risks, the order of severity, and preventive actions to track it.
Once threats are under control, it is possible to deliver the project on time
adhering to quality.
3. Project Execution
Project
execution is
the
phase
where
project-related processes
are
implemented, tasks are assigned, and resources are allocated. The method
also involves building deliverables and satisfying customer requirements.
Project managers or team leaders accomplish the task through resource
allocation and by keeping the team members focused.
The team involved will start creating project deliverables and seek to achieve
project goals and objectives as outlined in the project plan. The success of the
project mainly depends on the project execution phase. The final project,
deliverable also takes shape during the project execution phase.
There are a lot of essential things that are taken care of during the execution
phase. Listed below are a few among them:
A. Reporting Progress of a Project
During the project execution phase, it is essential to get regular project
updates as it provides the required information and even identifies the issues.
B. Hold Regular Meetings
Before you kick-off a project meeting, be clear about the agenda and make
team members aware of what the meeting is all about well in advance. If
communication is timely and straightforward, the productivity of ongoing
projects and those that are in the pipeline will not get affected.
C. Manage Problems
Problems within the project are bound to occur. Issues such as time
management, quality management, and a weakening in the team’s morale
can hinder the success of a project. So make sure all problems are solved in
the beginning.
4. Project Monitoring and Control
The project monitoring and control phase is all about measuring the
performance of the project and tracking progress. It is implemented during
the execution phase. The main goal of this phase is to check whether
everything aligns with the Project Management plan, especially concerning
financial parameters and timelines.
It is the responsibility of the project manager to make necessary adjustments
related to resource allocation and ensure that everything is on track. To aid
this, a project manager may conduct review meetings and get regular
performance reports.
Monitoring project activity after the project execution phase will allow the
project manager to take corrective actions. Meanwhile, considering the
quality of work will also help to make the necessary improvements. Keeping
an eye on the budget will help to avoid unnecessary expenses resources.
5. Project Closure
With much time and effort invested in the project planning, it is often
forgotten that the final phase of the Project Management life cycle phases is
equally important.
The project closure phase represents the final phase of the Project
Management life cycle, which is also known as the “follow-up” phase. Around
this time, the final product is ready for delivery. Here the main focus of the
project manager and the team should be on product release and product
delivery. In this stage, all the activities related to the project are wrapped up.
The closure phase is not necessarily after a successful completion phase
alone. Sometimes a project may have to be closed due to project failure.
Upon project completion and timely delivery to clients, it is the role of the
project manager to highlight strengths, list the takeaways of the project,
identify the ambiguities and suggest how they could be rectified for future
projects. Taking time to recognize the strengths and weaknesses will help to
handle projects with more dedication; this, in turn, builds the project
manager’s credibility.
Once the product is handed to the customers, the documentation is finalized,
the project team is disbanded, and the project is closed.
Characteristics of a Project Life Cycle
The
generic
life
cycle
structure
commonly
exhibits
the
following
characteristics:
•
At the start, cost and staffing levels are low and reach a peak when
the work is in progress. It again starts to drop rapidly as the project
begins to halt.
•
The typical cost and staffing curve does not apply to all projects.
Considerable expenses secure essential resources early in its life
cycle.
•
Risk and uncertainty are at their peak at the beginning of the project.
These factors drop over the life cycle of the project as decisions are
reached, and deliverables are accepted.
•
The ability to affect the final product of the project without
impacting the cost drastically is highest at the start of the project
and decreases as the project advances towards completion. It is clear
from figure 2 that the cost of making new changes and rectifying
errors increases as the project approaches completion.
These features are present almost in all kinds of project life cycles but in
different ways or to different degrees. The intent of the adaptive life cycles lies
particularly with keeping stakeholder influences higher and the costs of
changes lower all through the life cycle than in predictive life cycles.
Let’s take a look at how knowledge on project life cycle benefits an
organization:
•
It helps professional services teams to be more proficient and
profitable.
•
The project life cycle helps the organization.
•
It makes the flow of communication easier.
•
The knowledge emphasizes reporting and examining previous
projects.
Conclusion
After the successful accomplishment of the project, there may be a few
unexploited project resources, including the remnant budget, which can be
used by the project later. These are recorded as surplus resources and budget
to prevent wastage; this is the last of the Project Management steps before
the conclusion of the phases of the Project Management life cycle.
When you are running a project-based organization, every project that
is taken up is a stepping stone towards attaining long-term goals. As
mentioned earlier, a Project Manager is responsible for assessing and
analyzing every project that comes their way before moving forward.
The question is, why is it so important to have a project selection
criterion in place?
A project
requires several resources (human
and
non-
human), financials, a timeline, and other factors to become a reality.
In return, businesses are rewarded with considerable profit and
revenue and long-term clientele that improve overall profitability and
help meet goals and build a reputation. However, not every project
can align with your strategic point of view, and neither can each one
of these prove to be profitable. Moreover, sometimes you don’t even
have the right resource pool to do justice to the work.
In that case, you are investing your resources, their efforts, and your
company’s
finances
in
a
futile
area.
Moreover,
given
the
current market volatility, the resources are limited. If utilized in a
wrong project, it will incur more loss, and other critical projects will
suffer, showing a domino effect.
You can avoid these predicaments with a project selection method.
When
your
firm
and PMO
follow some
documented set
of
guidelines before accepting a project, they will evaluate every critical
attribute keeping you from facing the loss.
Strategic Alignment with business goals
Every business has its own set of strategic goals, a defined vision,
and a mission to project a clear path to success. That means every
project you work on should help you climb up the ladder to achieve
these strategic goals.
It will help you allocate your resources and their expertise to the right
place. Moreover, it keeps you from wasting time and efforts on
commitments that steer away from the organizational objective.
Assessment of resource capabilities and availability
Even though some projects might be the right fit for the firm and the
future goals, you may not have the right personnel to accomplish
them. Thus, the next important step towards ensuring a quality and
successful project delivery is assessing the resource capability matrix.
In
addition
to
that,
one
must
also
keep
a
note
of
their bandwidth and availability in advance. Otherwise, they might end
up over-utilizing the workforce, eventually causing burnout.
The Project Manager can equip a robust resource management tool to get
a birds-eye view of the skills matrix and resource capacity in advance.
With the ability to provide foresight into capacity vs. demand, resource
utilization, and other metrics, a tool will empower them to make datadriven decisions. Once the assessment is done, they can take the call
whether the project is feasible to continue with or not.
Evaluation of potential risks
Every project has its own set of risks and threats. The onus is on
the project managers to decide if they can be mitigated or not. Once
the project managers gauge their resource pool and give the goahead, the next step is to evaluate the potential risks they might face
diligently.
A prior risk assessment helps you first understand if it’s a high-risk or
low-risk project based on your pre-set risk appetite. In case it’s a lowrisk project, managers can even form a contingency plan well ahead
of the curve to prevent future bottlenecks. Implementing an intuitive
tool will ease the process of risk management as it will help
you simulate various project constraints and carefully assess the
result of variables.
The impact on customer satisfaction and brand loyalty
Maintaining the competitive edge and staying relevant during the
ongoing market uncertainties is of utmost importance for a firm. That
is only possible when your clients are happy with you and stay with
you in the long haul. Thus, the next fundamental in the criteria is
to study
the
impact
of
your
project on customer
satisfaction and brand loyalty.
The questions that need to be addressed are:
•
How will the final output of the project solve the existing
problems for the client?
•
Will the project improve the client’s perception of your firm’s
products and services?
Once Project Management team reaches a consensus and believes
the project can enhance customer satisfaction and improve your
brand loyalty, you will be in the right position to take up the
project.
Data Availability and Expected Revenue
Last but not least, finding out if you have enough data available on
the project and, if not, is it possible to collect data from varied
sources is imperative. When you are working on a project and the
essential data in place, implementing it at the right place and the
task becomes a breeze. Or else, your resources will have to
spend countless hours gathering the right information, analyzing
it, and then implementing it. In worse situations, limited data
availability can become
a
potential
roadblock in
a
project’s
progress.
Along with this, calculating the ROI (Return on Investment) or the
approximate revenue the project will generate is crucial. Because,
of
course,
you
do
not
want
to use
your
resources, skills,
time and effort, and your company’s finances on a low-revenue
generating project. It will not only lower your profitability but also
keep you from taking up a higher revenue-generating project.
Managers follow a benefit-evaluation model to calculate this. It is
discussed in the later sections in detail.
These are the fundamentals you must keep in mind while
developing a systematic project-selection criterion.
The Selection Models Used by
PMO
3.1 Benefits Measurement
As the name suggests, this model calculates the anticipated
revenue that can be the net profit that the firm can generate
after deducting the capital expenditure and taxes . In simple words, it
calculates the worth-creation of the firm while detailing the return
on capital.
o
Payback
Period
It is a basic selection model that gives you the time a project will
require to return the investments. The projects that have a
lower payback period are taken over those with a higher
payback period.
o
Scoring
Model
The scoring model is an objective selection method. The PMO
executives consider every relevant criterion and score them.
The value written against each is then cumulatively added to
rate the project. The one with the highest score is chosen.
o
Opportunity
Costs
The opportunity cost model tells you about what you will lose if you
give up a certain project. In this case, the project with the
lowest opportunity costs is taken up.
o
Discounted
Cash
Flow
This model evaluates the future value of money against the current
one. Of course, USD 2000$ won’t worth the same in the future.
It is a critical factor that should be given due importance while
selecting a project.
o
Net
Present
Value
(NPV)
It is the difference between the current cash inflow and the potential
outflow of a project. The only difference between the payback
period and NPV is that it considers the discounted cash flow rate,
enhancing its accuracy. Note that NPV must be positive for the
projects you plan to accept.
•
Internal
Rate
of
Return
The internal rate of return tells you the interest rate at which the NPV
becomes zero. It basically means when the inflow and outflow of
the project are equal. You will get an idea of project
profitability based on the IRR value.
Estimation of Working Capital
Requirements
In estimating working capital needs, different people adopt different approaches.
Some experts suggest that the working capital should be greater than the minimum
requirements of the firm. The management should feel safety. It would be able to
meet its obligations even in adverse circumstances. However, the excessive capital
may lead to waste and inefficiency. On the other hand, some experts suggest that the
working capital should be lower than the requirement so that no idle funds shall be
invested in the current assets and it ultimately leads to increase in profitability of the
company. However, in such case the firm always have risk of technical insolvency as it
may not meet its obligations as and when they falls due for payment.
So the question is what the proper amount of working capital is?. It is not an
absolute amount. It depends upon the needs and circumstances available in the firm.
There are various approaches which have been applied in practice for
the estimation of working capital requirements of a firm. Let’s discuss some of
them in brief.
1. Conservative Approach
The conservative approach states that the proportion of current assets to current
liabilities should be kept at 2:1. Is this proportion is to be kept the firm would be able
to meet its obligations on time and hence its financial solvency would not be in
trouble. However, the limitation of this approach is that it suggests only quantitative
measure. It does not suggest as to what type of assets are to be included in current
assets. If the current assets contain stock, which is outdated or receivable which are
not collectable, than the amount of current assets has no meaning. Further, in the
present scenario no firm maintains this ratio, as it’s too difficult for them to maintain
such a high level of current assets.
2. Components Approach
Here we take up one of the planning models of working capital to estimate working
capital. The method adopted here attempts at estimation of working capital and its
components by taking into account, the period for which the various items remain as
stock or as outstanding, the cost structure of production and annual production. It
assumes even production and even sales, throughout and what is produced is
completely sold.
3. Operating Cycle Approach
It was earlier referred to that working capital is also known as revolving capital. That
is, a circular path of conversion/re-conversion takes place. Consider this example.
You start your business operation with an initial investment. With credit extended by
expense creditors (labor, employees, utilities, etc.) you start production process.
Goods of varying levels of finish result. This is what we call as work-in-process or
work-in-progress. Once complete processing is done, you get finished goods. Until
these goods are sold, they remain in stock. Sales may be for cash and/or on credit
basis. You need to wait a little to realize cash from the credit customers. The realized
cash is used to pay creditors. You need to maintain a cash balance for day-to-day
transactions as well as for meeting sudden spurt in payment obligations
accompanied by sluggish cash collections from debtors. Thus a revolution or cycle
from cash to raw materials to Work in Progress (WIP), to finished goods, to debtors,
and back to cash is taking place. This revolution or cycle is known as operating cycle.
Efficient working capital management is one which ensures continuous flow without
any interruptions/holdups at any of the stages referred to above and involves as for
as possible a rapid completion of the revolutions. In other words, when raw materials
remain in store pending issue for production for a less duration, when raw materials
get converted into WIP in short duration, when WIP is converted into finished goods
in short duration, when finished goods remain in dept pending sales for a short while
only, and when cash realizations out of sales are made quickly and finally when
payment to creditors is made slowly, the operating cycle would be smaller and
consequently the working capital will also be reasonable.
There should be neither too little nor too much investment in working capital.
Efficient handling of the operating cycle would make possible the above. Note, what
is suggested is optimization, and not minimization of current assets and
maximization of current liabilities. That will affect your liquidity and your profitability.
Too little means more illiquid, but more profitability, but not more absolute profits.
We want both high profitability and high profits. Too much current liability means
illiquid but more profitability as it is assumed short-term funds are less expensive for
they can be redeemed the moment you don’t need thus saving interest. The reverse
is true with too little current liability. Actually the business has to trade-off between
risk and return. If it wants less risk it has to carry more current assets and less current
liability. This will lead to lower profits. Low risk means low profits. If the business
takes more risk, ie., it carries less working capital, it might make more profits. There is
no guarantee however that higher level of risk yields higher profits.
In terms of operating cycle concept, too long an operating cycle gives more liquidity
but only low returns and vice versa. The optimum operating cycle has to be worked
out taking into account the costs and benefits and levels of risk and levels of return
for varying lengths of operating cycle.
What is Project Cost Management?
Project cost management is the process of estimating, budgeting and controlling
costs throughout the project life cycle, with the objective of keeping expenditures
within the approved budget.
For a project to be called successful, it’s necessary that
•
•
•
•
it delivers on the requirements and scope
its execution quality is of a high standard
it’s completed within schedule and
it’s completed within budget.
Hence, project cost management is one of the key pillars of project management and
is relevant regardless of the domain, be it manufacturing, retail, technology,
construction and so on. It helps to create a financial baseline against which project
managers can benchmark the current status of their project costs and realign the
direction if needed.
Why is Project Cost Management Important?
The importance of cost management is easy to understand. To take a simple, reallife example, if you decide to build a house, the first thing to do is set the budget.
When you have a sense of how much to spend on the project, the next step is to
divide the high-level budget into expenses for sub-tasks and smaller line items.
The budget will determine critical decision points such as: which designer to hire—a
high-end one who will construct and deliver the project end-to-end, or someone who
can help with a few elements and be able to work for a smaller budget? How many
stories should the house have? What quality of materials should be used?
Without a predefined budget, not only is it difficult to answer these questions, but it
becomes impossible to assess whether you are progressing in the right direction
once the project is underway. In large organizations, the scale of this problem is
further magnified due to concurrent running of multiple projects, change in initial
assumptions and the addition of unexpected costs. That’s where cost management
can help.
By implementing efficient cost management practices, project managers can:
•
•
•
•
•
Set clear expectations with stakeholders
Control scope creep due to transparencies established with the customer
Track progress and respond with corrective action at a quick pace
Maintain expected margin, increase ROI, and avoid losing money on the
project
Generate data to benchmark for future projects and track long-term cost
trends
The Four Steps in Project Cost Management
While cost management is viewed as a continuous process, it helps to split the
function into four steps: resource planning, estimation, budgeting and control. They
are mostly sequential, but it’s possible that some resource changes happen midway
through the project, forcing the budgets to be adjusted. Or, the variances observed
during the control process can call for estimate revisions.
Let us look at each of these four steps in detail.
1. Project Resource Planning
Resource planning is the process of identifying the resources required to execute a
project and take it to completion. Examples of resources are people (such as
employees and contractors) and equipment (such as infrastructure, large
construction vehicles and other specialized equipment in limited supply).
Resource planning is done at the beginning of a project, before any actual work
begins.
To get started, project managers first need to have the work-breakdown structure
(WBS) ready. They need to look at each subtask in the WBS and ask how many
people, with what kind of skills are needed to finish this task, and what sort of
equipment or material is required to finish this task?
By adopting this task-level approach, it becomes possible for project managers to
come up with an accurate and complete inventory of all resources, which is then fed
as an input into the next step of estimating costs.
A few tips to consider during the process:
•
•
•
•
Consider historical data—past schedules and effort—before determining subtasks and the corresponding resources.
Take feedback from SMEs and team members—a collaborative approach
works well especially in projects that do not have past data to use.
Assess the impact of time on resource requirements. For instance, a resource
may be available only after a few months, dragging the project’s schedule.
This could have an impact on cost estimation.
Although this step happens at the planning stage, project managers need to
account for ground realities. For example, you may identify the need for a
resource with certain expertise, but if such a resource is not available within
the organization, you have to consider hiring a contractor or training your
team to get them up to speed. All these real variables impact cost
management.
2. Cost Estimation
Cost estimation is the process of quantifying the costs associated with all the
resources required to execute the project. To perform cost calculations, we need the
following information:
•
•
•
•
•
•
•
Resource requirements (output from the previous step)
Price of each resource (e.g., staffing cost per hour, vendor hiring costs, server
procurement costs, material rates per unit, etc.)
Duration that each resource is required
List of assumptions
Potential risks
Past project costs and industry benchmarks, if any
Insight into the company’s financial health and reporting structures
Estimation is arguably the most difficult of the steps involved in cost management as
accuracy is the key here. Also, project managers have to consider factors such as
fixed and variable costs, overheads, inflation and the time value of money.
The greater the deviation between estimation and actual costs, the less likely it is for
a project to succeed. However, there are many estimation models to choose from.
Analogous estimation is a good choice if you have plenty of historical cost data from
similar projects. Some organizations prefer mathematical approaches such as
parametric modeling or program evaluation and review technique (PERT).
Then there is the choice between employing a top-down versus bottom-up approach.
Top-down typically works when past costing data are available. In this, project
managers usually have experience executing similar projects and can therefore take
a good call. Bottom-up works for projects in which organizations do not have a lot of
experience with, and, therefore, it makes sense to calculate a cost estimate at a
task-level and then roll it up to the top.
Cost Estimation as a Decision Enabler
It’s useful to remember that cost estimation is done at the planning stage and,
therefore, everything is not yet set in stone. In many cases, project teams come up
with multiple solutions for a project, and cost estimation helps them decide which
way to go. There are many costing methodologies, such as activity-based costing,
job costing, and lifecycle costing that help perform this comparative analysis.
Lifecycle costing, for instance, considers the complete end-to-end lifecycle of a
project. In IT projects, for example, maintenance costs are often ignored, but
lifecycle costing looks long-term and accounts for resource usage until the end of the
cycle. Similarly, in manufacturing projects, the goal is to minimize future service
costs and replacement charges.
Sometimes the estimation process also allows teams to evaluate and reduce costs.
Value engineering, for example, helps to gain the optimal value from a project while
bringing costs down.
3. Cost Budgeting
Cost budgeting can be viewed as part of estimation or as its own separate process.
Budgeting is the process of allocating costs to a certain chunk of the project, such as
individual tasks or modules, for a specific time period. Budgets include contingency
reserves allocated to manage unexpected costs.
For example, let’s say the total costs estimated for a project that runs over three
years is $2 million. However, since the budget allocation is a function of time, the
project manager decides to consider just the first two quarters for now. They identify
the work items to be completed and allocate a budget of, say, $35,000 for this time
period, and these work items. The project manager uses the WBS and some of the
estimation methods discussed in the previous section to arrive at this number.
Budgeting creates a cost baseline against which we can continue to measure and
evaluate the project cost performance. If not for the budget, the total estimated cost
would remain an abstract figure, and it would be difficult to measure midway.
Evaluation of project performance gives an opportunity to assess how much budget
needs to be released for future phases of the project.
Another reason to firm up budgets is that organizations often rely on expected future
cash flows for their funding. During the initial phases, the project manager has a
limited financial pool and has to set targets accordingly. It’s similar to building the
foundation and one floor of the house in the initial few months and later completing
the rest of the project, as you save more.
4. Cost Control
Cost control is the process of measuring cost variances from the baseline and taking
appropriate action, such as increasing the budget allocated or reducing the scope of
work, to correct that gap. Cost control is a continuous process done throughout the
project lifecycle. The emphasis here is as much on timely and clear reporting as
measuring.
Along with the cost baseline, the cost management plan is an essential input for cost
control. This plan contains details such as how project performance will be
measured, what is the threshold for deviations, what actions will be done if the
threshold is breached, and the list of people and roles who have the executive
authority to make decisions.
Project Cost Software
Cost management, similar to other aspects of project management, gets complex
with many variables in play. The process itself is elaborate, needing attention to
detail along with a rigorous approach. The use of project management software can
simplify this process considerably.
Let’s look at a few advantages of using project cost management software:
•
Automation of cumbersome quantitative analysis during estimation and
measurement helps avoid manual errors
•
•
•
•
•
•
Integration of data across planning, estimation, budgeting, and control
enables continuous monitoring and quick, proactive responses, rather than
one-off interventions
Decision-making is made easier as cost software helps evaluate alternate
solutions using scenario forecasting and what-if analysis
Clear and easy reporting in the form of dashboards and other rich UIs
The complexity of multicurrency management in projects across different
geographical locations is simplified with project cost software
Many project cost solutions allow third-party integrations, so data can be
pooled and analyzed
Benchmarking and standardization are possible with the availability of
performance data across multiple projects
Cost Management and Enterprise Project Performance
In the 2018 PMI Pulse of the Profession Report, 41% of respondents said that their
projects are of high complexity. It’s no surprise then that 40% of the survey
participants consider “investing in technology to better enable project success” as
their top priority.
Cost management is closely tied to the capability of an organization to succeed in
current as well as future projects. Investing in reliable cost management software
can result in huge savings. A good solution to cost management will not treat it as a
siloed function but leverage it as integral to project and portfolio performance, and
correlate data across projects.
Visit these additional resources for more information on project cost management:
Product: EcoSys
Solutions: Project Portfolio Management, Project Controls & Project
Management, Earned Value Management
Process Area: Cost Control
Blog: 6 Best Practices for Project Controls, Foundations of Good Earned Value
Management
What is project cost estimation?
Cost estimating, by definition, is the practice of predicting the final total cost
of a project that has an outlined scope. It is the fundamental part of project
cost management (a discipline used by project managers since 1950 to
manage costs). Cost estimation validates the project budget and enables
the monitoring and controlling of project costs when the project is in
progress. The approximate project cost is then being referred to as a cost
estimate or a planned price. It includes all project expenses and is fairly
difficult to forecast, since the project scope is an ever-changing
phenomenon. Oftentimes, project cost estimation is much like looking into a
crystal ball.
Why project cost estimation is
important
There are many reasons why cost estimation is an indispensable part of
project management.
A cost estimate reflects if the project is financially viable. First things
first, an accurate cost estimate is essential for deciding if the project is
feasible or not for the company at the moment. In this light, a cost estimate
answers if the project can be completed with available resources in the
given time period and still bring value to the organization.
Cost estimation helps to stay on schedule and on track. At the end of
the day, sound project estimates are important to ensure that actual effort,
once the project is in progress, matches the estimated targets that were set
at the beginning of the project to the greatest possible extent. Thus
estimates are one of the foundational pillars for safeguarding client
expectations and your company’s bottom line.
The estimates of the work to be performed will always be the foundation for
your project. Unless you of course have a client with an unlimited supply of
cash and in that case you're probably the luckiest (and only) supplier in the
world.
Factors involved in project cost
estimation
It won’t hurt to repeat that cost estimation should cover each small element
required for the project - labor, material, training, you name it. And since it’s
difficult to account for all, initial cost estimates can rarely be called credible
and reliable. They are typically revisited and modified when the project’s
scope becomes more explicit.
In all cases, ensuring that you have priced your project correctly requires
that you have estimates you are fairly certain will hold water. When the
client has accepted the project and it starts going over time and budget it
can quickly turn your client and other stakeholders extremely sour. So let's
try to avoid this as best we can.
When calculating your project’s cost, you might benefit from distinguishing
between direct and indirect costs, as eventually your project price will have
to factor in both.
Direct & indirect costs
Direct costs are expenses closely related to your project. They will include
labor needed to complete the project together with software, equipment
and raw materials, depending on the industry you’re in. While the labor
(your employee’s salaries) is less fluctuating, the prices on equipment will
most likely vary.
In turn, indirect costs, also known as ‘overhead’ and ‘administrative’ entail
the spending on supplies that fuel your company’s day-to-day operations
as a whole, not appointed to the delivery of a particular project or service.
Office equipment, rent, and utilities can all be considered indirect costs.
Just like direct, indirect costs can be either fixed or variable.
Both types of costs are important and should be taken into account when
estimating a project.
Assuming that you’re in a company that provides professional services, the
typical cost categories include, but are not limited to human resources,
travelling spendings, training fees, material resources, research expenses,
contigency reserves, etc.
Common project cost estimation
techniques
Depending on your project type and size, stakeholder expectations,
potential billing method, and other project-related factors, various
techniques and tools can be applied to make an educated guess about the
project’s price.
Prime reasons for inaccurate project
cost estimates
More often than not, project cost estimates turn out to be off-the-mark. The
main reason being the timing when they’re made - during the proposal
phase - that is when you know the least about the project, plus many other
factors that compromise the quality of cost estimates. The common pitfalls
to watch out for that can destroy the accuracy and reliability of your
estimates are:
•
Farsighted predictions. Seasoned project managers know that every
estimate is a premature estimate if it’s made a long time in advance, let’s say
to predict the budget three years ahead. It immediately turns into a guess
estimate that will hardly be relevant then.
•
Shortage of expertise on similar projects. There is no denial of the fact that
better cost estimates come with experience on comparable initiatives.
Analogous projects inform your next estimation decisions by giving you a
clearer understanding of how the new project can be better scoped out and
which milestones take longer than usual.
•
Lack of requirements. Having an idea what the project is all about is not
enough. To provide an accurate estimate, every element in the project should
be specified per client’s request. Staying on the same page with the client will
help you break the project down into manageable chunks of work and ensure
that you don't miss out on anyone’s expectations.
•
Splitting one task across multiple resources. When more than one person
works on a task, clear processes should be set in place, which in turn requires
additional planning and management time, often not taken into account. Not
only does it make the task last longer, but it also increases chances of
overshot deadlines and estimates. In the end, one task divided between
multiple team members turns out to be more costly than you initially thought.
•
Expecting that resources will work at full battery. Total efficiency at
workplace is a utopia we all want to believe in. There will always be “dead
time” or unexpected non-billable work. A more reasonable number to target
would be 70-80%. Don’t forget to include that when scoping your next project.
Using spreadsheets for cost estimation
in project management
Spreadsheets are still widely used to estimate costs. However, before
entering the wonders of Excel spreadsheets again, we suggest weighing all
its positives and negatives.
The pros of using a spreadsheet for cost estimation
•
Almost an industry standard
•
Low barrier for entry (Most people have access to it and know how to use it)
•
Very adaptable and customizable
•
Easy to analyze, present, and pivot data (for a single project at least)
•
Easy to copy and distribute
The cons of using a spreadsheet for cost estimation
•
Very adaptable and customizable
•
Error-prone due to its manual nature
•
Only accessible locally and not by multiple people at the same time
•
Easy to copy and distribute (How do you easily merge input from 10 people?)
•
Almost impossible to consolidate input of data due to its delicate nature
•
No easy way to learn from previous projects and take advantage of historic
data
•
Rubbish at comparing projects and their data without substantial manual effort
•
No version control (Which always results in substantial rework)
•
Very hard to track Key Performance Indicators (KPIs) in a timely manner to
react to them
The list above indicates why it can make sense to grab a tool at hand like
Excel, but this on the other hand is also the major drawback of using
spreadsheets as they very fast end up being very complex and fragile due
to this ‘ease.’ The nature of spreadsheets makes them very delicate,
especially when multiple people have to work on the same sheet without
any form of version control. And yes, using a document repository (with or
without file locking) is still not a good solution.
Quickly a lot of manual rework needs to be done to make it work. Compiling
data across projects is also a process that is error-prone and needs
substantial manual effort if spreadsheets are the weapons of choice. Easily
taking advantage of previous project history and track record is thus, to our
experience, almost never done because it requires too much manual work.
When a business has the expertise and resources to undertake a
contract but lacks the funds to complete it, the lack of funding
may cost it the contract. The term contract financing refers to
how a business can receive advance funding on an awarded
contract it is yet to complete.
Most commercial contracts in the construction industry are paid
for in milestones throughout the process or fully at the end of
contract completion. In either case, business owners will need to
invest their own money to prepare and execute the specific
project.
For instance, the business will need to source funds for initial
tasks such as data analysis and sourcing materials and tools. If a
company cannot raise the funds it needs to execute or complete a
contract, the client may even cancel the entire contract and
choose to go with a competitor.
What Is Contractor Financing?
Contract financing is an excellent way for a business to access
business loans against a contract which it has already won. In
such a case, the lender will consider the creditworthiness of the
client and not the business’s when considering the funding
request.
Before funding the contract, the lender may analyze the terms of
the contract and especially payment milestones and timelines as
well as the contract price. Contract financing differs from
traditional bank loans in many ways. It is underwritten based on
the terms of a contract the business has already signed and the
creditworthiness of the client rather than the borrower’s assets or
credit record.
Contract financing is available to a business that has already won
a client contract and is ready to fulfill it once funds are available.
In some cases, the process of seeking contract financing may
begin long before the contract is awarded.
A good example of such a situation is when the client demands
proof of funds to meet the project’s costs before the business is
awarded the contract.
Clients seeking high-value or time-sensitive services may insist
that the business provides proof of funding before awarding the
contract. This demand is often required to assure the lender that
the project will be completed and not delayed or stalled due to a
lack of funds.
In such a case, the business may request the lender to issue a
‘letter of intent to fund’ to enable the business to win the
contract. As the name implies, this letter lets the client know that
the contract financing lender is prepared to advance funds to the
business should it win the contract.
Before the lender issues the letter of intent to fund the project,
they may demand business documents and details of the
contract. Lenders often require such documents as the business’s
profile, financial statements, and reference letters from previous
clients. These documents help the lender assess the business’s
credibility, resources, and capacity to fulfill the client contract.
How Contract Financing Works
Contract financing is different from a traditional business loan in
many ways. For starters, it is an unsecured loan, hence riskier
than the conventional secured loan. Because of this, the lender
may take extra precautions and look at more factors than they
traditionally would before approving a business loan. Here are the
three most notable factors that a lender will consider when
evaluating a business for a contract loan.
Monthly Billing
The amount of money a lender can advance a business will
largely depend on the borrower’s average monthly billing. This
does not refer to the average amount the business pays in bills
per month; rather, it refers to how much the company receives
from its customers in a month.
The lender will want to know that the business’s monthly income
is sufficient to cover the loan amount should the project client fail
to pay.
While the client’s contract is the collateral in this loan, the lender
will want to know that the business can cover the amount in a
reasonable time even without the contract milestones or
completion payments.
Time in Business
The duration in which the business has been in operation is one
of the most critical factors for contract financing. New businesses
are riskier than businesses with deep roots in their market; hence
lenders will be reluctant to loan them.
Most contract financing lenders will only consider businesses that
have been in operation for at least six months to a year.
However, the minimum operation period may vary depending on
the lender and their lending cap and the borrower’s industry.
Credit Rating of the Customer
A lender will scrutinize the creditworthiness of the contract client
before approving a loan because it is the client that pays the
loan. The lender will look at the client’s credit history, business
rating, and other factors before deciding whether to approve the
funding.
Often, the financier may advance the business as much as 90%
of the contract invoice amount, especially in a government
contract financing. It will want to know that the customer is good
for the money and will make invoice payments as per the
contract details without fail.
Types of Contract Financing
Contract financing can be categorized based on how the project
funds are monitored and controlled. Most lenders will put
measures in place to track and even control the contract
payments and expenses. The more established the borrower, the
less the lender will feel the need to manage the finances.
Here are the three types of contract financing options available to
a business:
1. Lender-Controlled Contract Financing
In this form of contract financing, the lender deposits the
borrowed funds into an account separate from the borrower’s
main account as per the contract terms. The lender will monitor
the movement of money in and out of the account throughout the
load duration. When the contract is completed and all payments
made, the lender will deduct charges from the account, transfer
the funds to the borrower’s account, then close the loan account.
2. Borrower-Controlled Contract Financing
In this form of contract financing, the borrower is in full control of
the contract as well as its finances. The funds may be deposited
into the contract account as a short-term loan or an overdraft.
While the loan may be used at the borrower’s discretion, the
lender will often monitor account transactions to ensure the funds
are responsibly managed and used for the contract only. The
lender may charge interest every month from the loan account
and the entire amount at the fulfillment of the contract.
3. Purchase Order Contract Financing
This contract loan caters to purchasing raw materials, inputs,
labor, packaging, service or product delivery, or other costs of
fulfilling the contract. With this contract financing type, the lender
may make direct payments to suppliers and service providers
rather than advance cash to the business. Because of its low risk,
this is a popular form of financing for new businesses or
companies with a less-than-excellent credit score.
Where to Get Contract Financing
Because contract financing is technically not a loan, banks
generally do not get involved in it. Instead, private firms such as
Billd that deal with factoring are often the go-to lenders for this
type of funding. Most of these firms operate or can be found
online and often offer different packages of the same type of
funding.
A business seeking contract finding may need to choose from
contract financing, accounts receivable factoring, and invoice
factoring. These firms are not as tightly controlled as banks;
hence, borrowers must take the time to understand the finer
details of contract financing offers before committing their
businesses to a funding offer.
FAQs About Contractor Financing
What is contract finance?
Contract finance is a form of funding that allows a business to
receive short-term loans or capital finance to undertake a
tendered contract.
Can you borrow money against a contract?
Yes. While the contract is the collateral for the loan, lenders will
often demand proof of capacity to cover the loan should the
contract fall through.
What does a contract financing payment mean?
This is an authorized disbursement of funds to a business before
the contract is completed.
How can you finance a government contract?
There are various ways your business can finance a government
contract, including invoice financing, purchase order financing,
supplier financing, accounts receivable refactoring, or asset-based
lending.
Do government contracts pay upfront?
It is not unusual for the government to pay a certain percentage
of a project cost up-front. However, most government contracts
detail the terms of payments to help businesses secure funding
from other sources. Typically, the final payment is paid upon
successful completion of the contract.
Project selection criteria are typically classified as:
A. Financial and non-financial
B. Short-term and long-term
C. Strategic and tactical
D. Required and optional
E. Cost and schedule
Which of the following financial models are typically included in project selection?
A. Payback
B. Net present value
C. Internal rate of return
‘
D. Both A and B are correct
E. A, B, and C are all correct
Projects are usually classified into all but one of the following categories. Which one is
not one of the typical classifications?
A. Compliance and emergency
B. Operational
C. Strategic
When you are running a project-based organization, every project that
is taken up is a stepping stone towards attaining long-term goals. As
mentioned earlier, a Project Manager is responsible for assessing and
analyzing every project that comes their way before moving forward.
The question is, why is it so important to have a project selection
criterion in place?
A project
requires several resources (human
and
non-
human), financials, a timeline, and other factors to become a reality.
In return, businesses are rewarded with considerable profit and
revenue and long-term clientele that improve overall profitability and
help meet goals and build a reputation. However, not every project
can align with your strategic point of view, and neither can each one
of these prove to be profitable. Moreover, sometimes you don’t even
have the right resource pool to do justice to the work.
In that case, you are investing your resources, their efforts, and your
company’s
finances
in
a
futile
area.
Moreover,
given
the
current market volatility, the resources are limited. If utilized in a
wrong project, it will incur more loss, and other critical projects will
suffer, showing a domino effect.
You can avoid these predicaments with a project selection method.
When
your
firm
and PMO
follow some
documented set
of
guidelines before accepting a project, they will evaluate every critical
attribute keeping you from facing the loss.
Strategic Alignment with business goals
Every business has its own set of strategic goals, a defined vision,
and a mission to project a clear path to success. That means every
project you work on should help you climb up the ladder to achieve
these strategic goals.
It will help you allocate your resources and their expertise to the right
place. Moreover, it keeps you from wasting time and efforts on
commitments that steer away from the organizational objective.
Assessment of resource capabilities and availability
Even though some projects might be the right fit for the firm and the
future goals, you may not have the right personnel to accomplish
them. Thus, the next important step towards ensuring a quality and
successful project delivery is assessing the resource capability matrix.
In
addition
to
that,
one
must
also
keep
a
note
of
their bandwidth and availability in advance. Otherwise, they might end
up over-utilizing the workforce, eventually causing burnout.
The Project Manager can equip a robust resource management tool to get
a birds-eye view of the skills matrix and resource capacity in advance.
With the ability to provide foresight into capacity vs. demand, resource
utilization, and other metrics, a tool will empower them to make datadriven decisions. Once the assessment is done, they can take the call
whether the project is feasible to continue with or not.
Evaluation of potential risks
Every project has its own set of risks and threats. The onus is on
the project managers to decide if they can be mitigated or not. Once
the project managers gauge their resource pool and give the goahead, the next step is to evaluate the potential risks they might face
diligently.
A prior risk assessment helps you first understand if it’s a high-risk or
low-risk project based on your pre-set risk appetite. In case it’s a lowrisk project, managers can even form a contingency plan well ahead
of the curve to prevent future bottlenecks. Implementing an intuitive
tool will ease the process of risk management as it will help
you simulate various project constraints and carefully assess the
result of variables.
The impact on customer satisfaction and brand loyalty
Maintaining the competitive edge and staying relevant during the
ongoing market uncertainties is of utmost importance for a firm. That
is only possible when your clients are happy with you and stay with
you in the long haul. Thus, the next fundamental in the criteria is
to study
the
impact
of
your
project on customer
satisfaction and brand loyalty.
The questions that need to be addressed are:
•
How will the final output of the project solve the existing
problems for the client?
•
Will the project improve the client’s perception of your firm’s
products and services?
Once Project Management team reaches a consensus and believes
the project can enhance customer satisfaction and improve your
brand loyalty, you will be in the right position to take up the
project.
Data Availability and Expected Revenue
Last but not least, finding out if you have enough data available on
the project and, if not, is it possible to collect data from varied
sources is imperative. When you are working on a project and the
essential data in place, implementing it at the right place and the
task becomes a breeze. Or else, your resources will have to
spend countless hours gathering the right information, analyzing
it, and then implementing it. In worse situations, limited data
availability can become
a
potential
roadblock in
a
project’s
progress.
Along with this, calculating the ROI (Return on Investment) or the
approximate revenue the project will generate is crucial. Because,
of
course,
you
do
not
want
to use
your
resources, skills,
time and effort, and your company’s finances on a low-revenue
generating project. It will not only lower your profitability but also
keep you from taking up a higher revenue-generating project.
Managers follow a benefit-evaluation model to calculate this. It is
discussed in the later sections in detail.
These are the fundamentals you must keep in mind while
developing a systematic project-selection criterion.
The Selection Models Used by
PMO
3.1 Benefits Measurement
As the name suggests, this model calculates the anticipated
revenue that can be the net profit that the firm can generate
after deducting the capital expenditure and taxes . In simple words, it
calculates the worth-creation of the firm while detailing the return
on capital.
o
Payback
Period
It is a basic selection model that gives you the time a project will
require to return the investments. The projects that have a
lower payback period are taken over those with a higher
payback period.
o
Scoring
Model
The scoring model is an objective selection method. The PMO
executives consider every relevant criterion and score them.
The value written against each is then cumulatively added to
rate the project. The one with the highest score is chosen.
o
Opportunity
Costs
The opportunity cost model tells you about what you will lose if you
give up a certain project. In this case, the project with the
lowest opportunity costs is taken up.
o
Discounted
Cash
Flow
This model evaluates the future value of money against the current
one. Of course, USD 2000$ won’t worth the same in the future.
It is a critical factor that should be given due importance while
selecting a project.
o
Net
Present
Value
(NPV)
It is the difference between the current cash inflow and the potential
outflow of a project. The only difference between the payback
period and NPV is that it considers the discounted cash flow rate,
enhancing its accuracy. Note that NPV must be positive for the
projects you plan to accept.
•
Internal
Rate
of
Return
The internal rate of return tells you the interest rate at which the NPV
becomes zero. It basically means when the inflow and outflow of
the project are equal. You will get an idea of project
profitability based on the IRR value.
What Is Financial Structure?
Financial structure refers to the mix of debt and equity that a company
uses to finance its operations. This composition directly affects the risk
and value of the associated business. The financial managers of the
business have the responsibility of deciding the best mixture of debt
and equity for optimizing the financial structure.
In general, the financial structure of a company can also be referred to
as the capital structure. In some cases, evaluating the financial structure
may also include the decision between managing a private or public
business and the capital opportunities that come with each.
Understanding Financial Structure
Companies have several choices when it comes to setting up the
business structure of their business. Companies can be either private or
public. In each case, the framework for managing the capital structure is
primarily the same but the financing options differ greatly.
Overall, the financial structure of a business is centered around debt
and equity.
Debt capital is received from credit investors and paid back over time
with some form of interest. Equity capital is raised from shareholders
giving them ownership in the business for their investment and a return
on their equity that can come in the form of market value gains or
distributions. Each business has a different mix of debt and equity
depending on its needs, expenses, and investor demand.
Private versus Public
Private and public companies have the same framework for developing
their structure but several differences that distinguish the two. Both
types of companies can issue equity. Private equity is created and
offered using the same concepts as public equity but private equity is
only available to select investors rather than the public market on a
stock exchange. As such the equity fundraising process is much
different than a formal initial public offering (IPO). Private companies
can also go through multiple rounds of equity financing over time which
affects their market valuation. Companies that mature and choose to
issue shares in the public market do so through the support of
an investment bank that helps them to pre-market the offering and value
the initial shares. All shareholders are converted to public shareholders
after an IPO and the market capitalization of the company is then valued
based on shares outstanding times market price.
Debt capital follows similar processes in the credit market with private
debt primarily only offered to select investors. In general, public
companies are more closely followed by rating agencies with public
ratings helping to classify debt investments for investors and the market
at large. The debt obligations of a company take priority over equity for
both private and public companies. Even though this helps debt to come
with lower risks, private market companies can still usually expect to
pay higher levels of interest because their businesses and cash flows
are less established which increases risk.
Debt versus Equity
In building the financial structure of a company, financial managers can
choose between either debt or equity. Investor demand for both classes
of capital can heavily influence a company’s financial structure.
Ultimately, financial management seeks to finance the company at the
lowest rate possible, reducing its capital obligations and allowing for
greater capital investment in the business.
Overall, financial managers consider and evaluate the capital structure
by seeking to optimize the weighted average cost of capital (WACC).
WACC is a calculation that derives the average percentage of payout
required by the company to its investors for all of its capital. A simplified
determination of WACC is calculated by using a weighted average
methodology that combines the payout rates of all of the company’s
debt and equity capital.
Metrics for Analyzing Financial Structure
The key metrics for analyzing the financial structure are primarily the
same for both private and public companies. Public companies are
required to file public filings with the Securities and Exchange
Commission which provides transparency for investors in analyzing
financial structure. Private companies typically only provide financial
statement reporting to their investors which makes their financial
reporting more difficult to analyze.
Data for calculating capital structure metrics usually come from the
balance sheet. A primary metric used in evaluating financial structure is
a debt to total capital. This provides quick insight on how much of the
company’s capital is debt and how much is equity. Debt may include all
of the liabilities on a company’s balance sheet or just long-term debt.
Equity is found in the shareholders’ equity portion of the balance sheet.
Overall, the higher the debt to capital ratio the more a company is
relying on debt.
Debt to equity is also used to identify capital structuring. The more debt
a company has the higher this ratio will be and vice versa.
KEY TAKEAWAYS
•
•
•
•
Financial structure refers to the mix of debt and equity that a
company uses to finance its operations. It can also be known as
capital structure.
Private and public companies use the same framework for
developing their financial structure but there are several
differences between the two.
Financial managers use the weighted average cost of capital as
the basis for managing the mix of debt and equity.
Debt to capital and debt to equity are two key ratios that are used
to gain insight into a company’s capital structure.
Financing and Financial Closure
• One of the important stage in project life cycle is to
decide the ‘sources of finance’ and finalise the ‘financial
closure’.
• During project life cycle various sources of finance are
available which carry different terms, conditions, rules,
maturity period, repayment schedules so study of these
factors and thereby deciding the sources of finance is
very crucial.
Importance of Project Financing • Project Cost
• Cost of project will be
affected by sources of
funds carrying lower
cost, easy and timely
availability.
• Cost over-run and time
over-run
• Cheap and easy available
finance will facilitate
timely completion of
project.
Importance of Project Financing • Better profitability
• Quicker financial closure
• Other benefits
• Low cost of finance will
improve profitability.
• Easy mix of sources of
financing will help
quicker financial closure.
• Low interest burden, low
depreciation, income tax,
pricing of product,
repayment of loan.
Important issues in
Financing Of Project •
•
•
•
•
•
•
•
•
Modes of Finance
Cost of Capital & Capital Structure
Lending policies and appraisal norms of financial
institutions
Project financing and venture capital
Dividend policies
Corporate taxation and its impact
Exchange risk management
International Financial Management
Leverage analysis and financial decisions etc.
Modes of Finance • Modes of Finance may include financing through sale
of equity shares, debentures, bonds etc. market related
products for which adherence to SEBI Guidelines may
be necessary.
• If financing is through Financial Institutions/ banks
then relevant guidelines/norms need to be considered.
• Other modes of financing may include ECB, FDI,
GDR, Joint venture, lease financing, Deferred
payments arrangements etc.
Cost of Capital & Capital Structure
• Capital Structure means determining the ratio of debt
and equity capital in the total project capital.
• Each type of capital viz. equity or debt carries some
cost which varies from one type to another.
• Therefore, proper mix of finance so as to reduce the
overall cost of capital is necessary to improve the
profitability.
Lending policies and appraisal
norms • While giving finance, banks and financial institution will
follow their own norms. These conditions have to be
complied by the borrower.
• The normal conditions in the loan agreement shall
include rate of interest, repayment schedule, progress
reports, cost and time over-run, details of project
consultants etc.
• In addition, bank may include special conditions like
pledging of promoters equity, appointment of
concurrent auditors, appointment of nominee director
etc.
Project financing and venture capital
• Venture capital refers to investment in new in untried
enterprises that lacking a stable record of growth.
• It is in the form of equity or quasi-equity instruments.
• The venture capitalist joins the entrepreneur as a copromoter in project and shares the risk and rewards
with the objective of long term capital appreciation.
Dividend Policy • Dividend policy refers to decision as to how
much profit is to be retained &/or distributed.
• By retaining profits net worth will increase
making further availability of funds.
• Distribution of profits may increase share prices
on the other hand.
Taxation and its impact on financing
• Mode of financing will have direct impact on
corporate taxation.
• For e.g. more the debt in the capital mix more
may be the interest cost which will reduce
profits and thereby taxes.
• Therefore deciding proper mix of source is
necessary from taxation view as well.
Other important Issues • Cost escalations clauses to be included in
Foreign financing transactions so as to make
variations due to change in rates.
• Weighted Average Cost of Capital i.e. the sum
of cost of various sources divided by sum of
funds obtained is to be kept at minimum so as
to improve the profitability.
Negotiation of term loans with
banks • Negotiation to be made on following points • Alternative sources available
• Rates charges by sources of agencies
• Quantum of funds required
• Repayment schedules & other points
International Financial Management
• While negotiating the loan from international
sources following points should be considered• Terms and conditions
• Exchange rates
• Repayment schedules
• Exchange fluctuations
• Documentation / guarantees to be executed
Other issues • Infrastructure Development Finance Company
may be incorporated to provide source of
finance for infrastructure development.
• Deficit Financing is done by govt. when Annual
expenditure exceeds the annual income.
• Legal issues, provisions of law, act enactments
etc.
Leverage analysis and financing • A ratio between debt financing and equity
financing is called leverage ratio.
• Leverage ratio indicates to what extent the
organisaiton has financed its investments from
the borrowed funds.
• Leverage analysis requires study of factors like
earnings of equity shareholders, interest burden,
taxation impact and risk factors.
Sources of finance • Sources of finance • Medium and long term
sources ( National )
• Internal Sources
• Short term sources
• International sources
• Other misc. sources
•
•
•
•
•
•
Examples –
Equity shares, venture
capital, debentures etc.
Retained earnings
Cash credit
Euro issues
Commercial papers,
NBFCs etc.
Medium & long term sources
(National) • Venture capital is the capital provided for new
business ventures. The venture capitalist joins
the entrepreneur as a co-promoter in project and
shares the risk and rewards with the objective of
long term capital appreciation.
• Seed capital i.e. initial contribution made by
owner, is returnable after function is over.
Medium & long term sources
(National) • Equity share capital is contributed by promoters and
owners of the company which is refundable at the time
of liquidation.
• Preference share capital is capital having preference
over equity capital owners for dividend & capital
repayment.
• Debentures are borrowed funds which may be
convertible into shares at a later date.
Medium & long term sources
(National) • Hire purchase involves acquiring of equipments
by paying the price through easy and convenient
installment.
• Leasing is a long term form of finance where
Fixed assets are purchased on lease basis where
ownership lies with lessor, but used by the
company in return of lease rentals.
Medium & long term sources
(National) • As per Provisions of Companies Act, deposits
may be collected from the public for investing in
the company subject to fulfilling of certain terms
and conditions.
• Bonds are also one of the important source of
finance where funds are raised through sale of
bonds after approval of Ministry of Finance.
Internal sources • Internal sources include the following –
•
•
•
•
•
Retained earnings
Earmarked Provisions
Dividend policy
Bonus shares
Sale of idle assets.
Short term sources • Loan from commercial banks in the form of cash credit,
overdraft, bills, bank guarantees, letter of credit etc. is an
important form of short term sources.
• Trade credit are provided by few banks to customers to enhance
their business.
• Government subsidies i.e. funds allocated by Government for
specified projects, e.g. Grants given by department of electronics
for development of information technology.
• Deferred credit facility where the repayment is deferred instead
of making immediate repayments of loans.
International sources •
•
•
•
•
•
•
Fund raising through foreign markets
Investments in foreign projects
Euro issues
ECB i.e. external commercial borrowings
ADRs (American Depository Receipts)
GDRs (Global Depository Receipts)
International finance and syndication of loans
Miscellaneous sources of finance • Public loans are available in the form of bonds at fixed
rate of interest.
• Joint ventures by way of equity participation by two or
more owners in new project can be a good source of
finance.
• Contract financing mode where till completion of
project interest will be capitalized and after project is
complete it will be charged to revenue.
Miscellaneous sources of finance • Commercial papers are issued by the companies
for Short term source to meet working capital
needs.
• Inter corporate loans are also taken to meet
working capital requirements, by following
provisions of Companies Act.
Miscellaneous sources of finance • Non-banking finance companies (NBFC’s) have
emerged as lenders for equipment leasing, hire
purchase, loan & other investment proposals.
• Barter system is also followed in some cases where
payment of Contractor’s bills is made in the exchange
of Company’s goods.
• Foreign aids are available from Developed countries for
housing, welfare, hospital, education, environmental
improvement etc.
Financial Closure
• Financial closure means completion of following steps • Finalisation of sources of finance
• Amount of loan, syndicated loan, guarantee formalities
etc.
• Fixation of Terms and conditions
• Fixation of Rates of interest
• Release of funds
• Deciding of Repayment schedules
• Execution of loan agreement
Cost of Capital
• Important in deciding the optimum capital structure of
the company. Proper optimum mix should be
maintained in the capital structure.
• Decision of sources of finance will depend upon:
• Company’s policy
• Government’s guideline
• Rate of interest
• Repayment period and other terms and conditions of
loan
New reforms in Project Finance • Raising of ADRS, GDRS, ECB
• Globalisation
• More Autonomy to banks
• More powers of financial institutions
• Lower rates of interest
Latest changes in Finance • Syndication of loans is also being commonly done now
a days.
• In case of lending, banks having 70% or more exposure
to unit can change management of the company.
• Financial institutions lend only medium term funds.
• World bank assistance is available for infrastructure
projects.
• RBI is taking more actions on risk management.
Latest techniques for reducing
financing cost
• Swapping of loan by substituting high cost loan
with the low cost loan
• Temporary switching rupee and foreign currency
loan with full hedging.
• Lease finance at fine rates.