Financial indicators

A number of financial indicators are used to assess the financial viability of a project as well as alternative financial structure for its implementation. Some of the main indicators include:

Return on Equity. The net income earned on an equity investment. It measures the investment return on the capital invested by shareholders and should not be less than the expected return on equity.

Annual Debt Service Coverage Ratio. It is a measure that calculates the cash flow for a period in relation to the amount of loan interest and principal payable for that same period. The ratio should be (at the minimum) equal to or greater than 1 as that demonstrates that the project is earning enough income to meet its debt obligations. It is an important criterion used by financiers to monitor financial performance of a project.

Project Life Coverage Ratio. It is also similar to debt service coverage ratio but considers debt service coverage on a given date based on future cash flows from that date until the end of the project life. This ratio enables lenders to assess whether or not there would be sufficient cash flow to be able to service the debt in the event that the debt needs to be restructured.

Payback period. The length of time needed to recover initial investment on a project. It may be determined using either discounted cash flow or non-discounted cash flow.

Net Present Value. It is the sum of the present value of all future cash flows. The present value refers to discounted value34 of cash flows at future dates. A project is considered for investment if its NPV is positive.

Internal Rate of Return. It is the discount rate at which the net present value of the cash flow of a project is zero. The IRR may be calculated based on either economic, or financial (i.e., market) prices of all costs and revenues (or benefits). If the financial IRR is less than the cost of capital, it implies that the project would lose money. If the economic IRR is less than the opportunity cost of capital (i.e., a predetermined cut-off rate of investment), the project is not considered economic from the point of view of economy.

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34 Discounted present value is a method of measuring the return on investment which takes into account the time value of money. If alternative investment opportunities exist, money can be shown to have a time value because, for example, US$ 100 today invested at 10 per cent will yield US$ 110 in one year’s time. Conversely, US$ 110 to be received in one year would be worth $100 now. The technique used to calculate the present value of a known future worth at a given discount rate is called discounting. It is the reverse of compounding which calculates the future value of a present investment at a given interest rate.