What are financial models? Who uses them? Why are they important?
There are many types of financial models and they all serve a general purpose: representing the real world financial situation. These models are used for different purposes, and at Arbox, we have spoken to more than 200 asset managers, and we will show you a few widely used financial models in the renewable asset management industry. Financial models are important because they are used by a range of players such as financing and valuation entities, investors, solar farm owners, PV manufacturers, and policy makers to evaluate investment risk and lend insights into portfolio management. In the paragraphs below, we will introduce a few financial models and the elements you should consider for your financial models.
Your financial models should accurately represent the revenue patterns of your business by establishing precise relationship between technical information such as plant performance, degradation, and solar irradiance levels and revenue. Another consideration is the level of government subsidy and tariff. Your financial model should reflect the flow of subsidy and capture the unique structure of your PPA. On the cost side, it is important to capture the inflation level and the tax structure unique to your company as part of financial forecasting.
Risk evaluation models
You should also consider risk assessment models because investors and banks use them to evaluate the risk and viability of investing in your projects, and risk assessment can reflect the manageability, severity, and probability of asset failures.
Types of risk evaluation models
There are a number of risk assessment tools available with each serving a specific purpose. For instance, cash flow models such as NPV and IRR evaluate asset performance under regular operating conditions and shows the economic risk and profitability of an investment, while technical risk models emphasize the different risk characteristics throughout asset lifecycle and the associated asset failure costs.
In the paragraphs below, we will discuss two cash flow models commonly used to evaluate investment risk and profitability.
IRR is used by many financial stakeholders to evaluate the profitability of an investment and for lenders to the conduct risk assessment.
Managers use IRR to rank the returns of projects, and the project with higher IRRs is preferred. In feasibility analysis, IRR is often called the “hurdle rate” because if IRR is greater than company’s required rate of return, the project should be undertaken. IRR also measures risk because it implies how much inflation rate needs to reach before making NPV zero. However, IRR does not work well when two projects have different durations, and when cash flows are negative over project lifetime. Furthermore, IRR gives you a rate but doesn’t show you the net dollar return on an investment. For these reasons, IRR should not be used by itself and must be used in combination with other financial indicators.
NPV is similar to IRR and uses expected cash flow to evaluate viability of an investment. NPV shows the discounted net return on a project and closely reflects risk as the discount rate reflects the level of project risk. NPV is often used in combination with IRR to provide a more accurate representation of investment viability.
Your portfolio comprises of individual renewable plants or projects, so the portfolio risk and return depend on the projects you include in the portfolio. Asset owners typically combine projects with varying characteristics to balance the level of risk and achieve a stated rate of return.
The HAP® Platform
HAP® provides a comprehensive suite of financial models that help you make smart financial and portfolio management decisions, and the models can also be customized to reflect unique financial needs. HAP® also allows you to see the best and worst-case scenario for cash flow and compare estimated with actual cash flow.
Contact us today to see how HAP® can help you manage your activities efficiently and boost your bottom line.