The difference between Financial Analysis and Economic AnalysisJune 10, 2018
Financial and Economic analyses are essentially used to determine the costs incurred and the resulting benefits from investing in a project. They both involve ascertaining the NPV or the net present value of a project based on its estimated present and future cash flows, appropriately discounted. Both techniques, however, differ in their implications and hence also in what is defined as a cost and a benefit.
Financial Analysis is largely confined to individual organizations or their units. It involves a fairly quantitative, fund-based approach that directly compares the expenses and revenues from a venture to determine profitability and hence sustainability. Such evaluation may often employ the financial statement of an enterprise – the balance sheet, the income statement and the cash flow statement.
For instance, consider an oil drilling company evaluating an independent project – the setting up a new well. If the present value of the annual cash flows were to exceed the initial investment and other costs such as taxes, possible interest payments and operational expenses, the project would be looked upon favorably. Additionally, the firm might also look at the project’s effect on its financial ratios to be certain about feasibility.
Economic Analysis, on the other hand, takes a much wider view and entails the impact of a project on society as a whole. It considers the viewpoints of all stakeholders and how the results of a project align with the broader economic and social policies as well as the International scenario. The costs in an economic analysis are a measure of the resources that a society collectively invests for the fulfilment of the project. The benefits, however, need not be just monetary and often include intangible benefits.
In the above oil well case, for instance, the economic analysis deals with not just the profits from an industry perspective. Instead, negative externalities such as pollution, displacement and deforestation are treated as costs awhile positive externalities such as employment generation which is considered benefits. Determining a quantitative measure of such factors remains a challenge.
Treatment of Taxes and Subsidies
Financial analysis tends to rely on exact market prices for calculating costs. Taxes are treated as costs and subsidies as returns. They are both assumed to already reflect in these market prices and any adjustments are therefore unnecessary.
In economic analysis, the market price is often modified to arrive at what is popularly known as the ‘shadow price’ or ‘economic price’. Taxes are levied on a project’s returns and are collected by the government itself. Similarly, subsidies are funds that society as a whole invests into the project, therefore necessitating differential treatment.
Treatment of Interest Payments
Interest payments are treated as a cost in financial analysis as they are the additional amount that the stakeholder has to pay to external bodies along with returning the borrowed capital. Often these interest payments are incorporated into the evaluation of NPV in the discounting factor – the internal rate of return.
From an economic perspective, however, interest on capital invested by society is also returned to society as a gain on the capital, thus again removing the need for any separate computation.
A study of financial feasibility versus economic feasibility can help develop a further understanding of the two topics. Financial feasibility is based strictly on profitability and sustainability. A financially feasible project, therefore, might not be economically viable if the overall impact on society is negative. On the contrary, an economically viable project may not always be financially sustainable. The government may, however, choose to take up such a project by supplying additional funds, owing to its positive impact on society.