Catalog

Objective:
Effective financial management is a critical success factor for project sustainability. Irrespective of how well a particular project or program is designed and implemented, if the executing or implementing agency does not have the capacity to effectively manage its financial resources, the benefits of the project are unlikely to be sustainable. The FMA includes a review of the entity's systems for financial and management accounting, reporting, auditing and internal controls. It also involves a review of the entity's disbursement and cash flow management arrangements. The FMA is not an audit, it is a review designed to determine whether or not the entity's financial management arrangements are sufficient.

Approach and Methodology:
The first step is to determine whether a FMA has been completed by either ADB, the World Bank or any other development partner (the objective is to avoid duplicating diagnostic work that already exists). If a FMA exists, this should be updated as required. If a FMA has never been completed, or if there have been significant changes which render the FMA obsolete, then the following approach to the FMA is recommended:

• Review country diagnostic studies including: Country Financial Accountability Assessment (CFAA), Country Procurement Assessment Report (CPAR), Country Governance Assessment (CGA), Diagnostic Study on Accounting and Auditing (DSAA).
• If planning to rely on the work of another donor (i.e. World Bank's Financial Management Assessment for the same executing agency), review the agency's methodology and assessment report to determine whether or not the results of the FMA are reasonable and can be accepted by ADB. Update the FMA as required. If the work of another donor has been relied on, this should be noted in the RRP.
• Preferably early in project preparation, have the Executing Agency complete the Financial Management Assessment Questionnaire (FMAQ)
• Review responses on the FMAQ, determine what, if any, additional information is required to be able to conclude whether or not the financial management arrangements are capable of recording all transactions and balances, supporting the preparation of regular and reliable financial statements, safeguarding the entity's assets, and are subject to audit.
• Review past management letters to assess what concerns have been previously raised on internal controls.
• Form a conclusion with respect to whether or not the financial management arrangements and financial and project accounting systems can be relied upon for the purposes of the project.
• If issues and/or weaknesses are identified, determine the most appropriate mitigation measures (i.e. including a project component to strengthen financial management, establishing or strengthening a project implementation or project management office, specific project implementation or monitoring procedures, etc.)
• Once cost estimates have been finalized, and procurement arrangements agreed, determine the most appropriate disbursement arrangements (including the need and/or capacity to manage an imprest account).

Documentation:
A brief summary of the FMA, including disbursement arrangements, should be provided in the RRP. Results of the review of existing diagnostic studies, the completed FM AQ and brief assessment report should form part of the divisional files.

Program Loans:
Given the budgetary implications of program lending, the financial management assessment for program loans should attempt to assess the capacity of the borrowing government to effectively manage financial resources. The Charter obligation that ADB funds be used for their intended purpose applies equally to project and program lending. Auditing use of program lending is less relevant in many cases. Therefore, the FMA should focus more on an assessment of public financial management and the following approach is recommended:

• Review of the relevant country diagnostic studies with a focus on central government systems and funds management practices
• If loan proceeds are to be provided to a line ministry, audited financial statements for the ministry as a whole, based on the Government's chart of accounts, should be sought
• If significant weaknesses exist in country systems, consideration should be given to providing assistance to address these weaknesses

Sector Loans:
As indicated in OM D3, a sector loan requires completion of a detailed sector analysis. This sector analysis includes review of the expenditure structure, sustainability of investments, intrasectoral resource allocations etc. The financial management within the sector should be clearly reviewed and documented as a component of the overall sector analysis.

Sector Development Program Loans:
As defined in OM D5, a sector development program combines a program (policy) loan together with an investment loan. The financial management assessment should cover both the program loan aspects (as noted above) as well as a review of the EA's financial management capacity with respect to the investment component.

4.1
4.2.6.3


4.2.8; 4.2.9


7.7; 7.8; 7.9


4.1.6;
FM Addendum p.3,
FM Addendum p.9







FM Addendum p.31




FM Addendum p.14;
7.7.1.4.5;
7.8.1.4.6;
7.9.1.4.5;
FM Addendum p.24



4.2.1;
FM Addendum p. 31

4.2.1; 4.2.2;
FM Addendum p. 31


FM Addendum p. 31








4.1.3

1.2.1





4.2.6.1.7

4.2.2.1






2.2.3

Cost Estimates:
Cost estimates can be prepared either through the use of COSTAB (software available on www.adb.org) or based on engineering estimates using MS Excel. In preparing cost estimates, the following approach is recommended:

• Project costs are computed in domestic currency units, with foreign exchange costs translated into domestic currency units at the projected exchange rate for the year of expenditure
• Project costs are prepared in nominal terms, taking into account the effects of inflation and foreign currency fluctuations
• Purchasing power parity is the base assumption, with exchange rates expected to fluctuate in accordance with the following formula:

ERn = ER n-1 * [(1+i(d) n-1)/(1+i(f) n-1)]

where ER n Exchange Rate Year n
ER n-1 Exchange Rate Year n-1 (year of base cost estimate)
i(d) n-1 domestic inflation rate year n-1
i(f) n-1 international inflation year n-1

• Cost estimates should be produced in constant base year prices, with "year 0" being the year in which the project will be considered by the Board.
• Physical contingencies are based on engineering estimates and/or specifics with respect to the project components. Physical contingencies should be based on risks and can be computed on a component by component basis.
• Using the drawdown schedule, price contingencies are based on projected domestic and international inflation rates as projected by ERD and posted on the ADB intranet (http://lnadbg1.asiandevbank.org/erd0004p.nsf/). The price contingency should be computed from the first year following the base year, for example, if costs are produced in 2000 prices, then the price contingency should be computed from years 2001 onward. As base cost estimates are to be no more than six months old at the time of board consideration, the price contingency for the first year (i.e. 2001) should be 50 of the computed total. From the second year onward, the full price contingency is assumed
• With respect to Sector Projects, GP5 (Sector Lending) indicates that physical and price contingencies are not required. However, contingencies must be computed, and presented in the detailed cost estimates, for candidate subprojects. If sufficient information is known with respect to the subprojects, it is suggested that contingencies be computed (on the basis of engineering estimates) with a footnote indicating that the taxes and duties and contingencies include estimates for future subprojects based on indicative cost estimates and will be re-calculated as subprojects are being evaluated.
• Interest and other financing charges during construction are capitalized and computed using interest rates in effect at the time of project appraisal. On ADB debt, the front end fees and/or commitment charges may be applied (refer to ADB's loan regulations)
• In computing the interest during construction for variable, or floating rate debt (i.e. ADB's LBL product), the applicable 5-year fixed swap rate should be assumed plus a provision for ADBs spread of .6%. This rate is updated daily and is available on the internet at:
http://www.adb.org/Documents/Brochures/Libor/indicative_rates.pdf
• The cost estimate table in the RRP should be presented in USD. However, a detailed cost estimate table, in both domestic currency and USD may be provided as an Appendix to the RRP or in a supplementary appendix.
• The cost estimate table in the RRP should disclose taxes and duties as a separate line item.
• The assumptions made in preparing costs, together with electronic copies of financial models prepared, should be retained in the division files for later user in PCRs or PPARs.

Financing Plan:
In preparing the financing plan, the following approach is recommended:

• The financing plan should be prepared in domestic currency units, with foreign exchange funds being translated into domestic current units at the projected exchange rate for the year of drawdowns.
• The drawdown schedule should be estimated on the basis of annual expenditure projections.
• The financing plan should cover base costs, physical and price contingencies, interest and other charges during construction and project foreign exchange gain or loss as applicable.
• The veracity of the financing plan should be addressed, including assessment of the EA's capacity to provide counterpart financing (self-financing), availability of "space" within the national and/or local government budget to support the project, the firmness of local bank, commercial or donor co-financing etc.
• The financing plan table in the RRP should be presented in USD. However, details, in both domestic currency units and USD may be presented on the detailed cost estimate appendix or supplementary appendix.
• The financing plan should indicate percentage of total cost to be funded from each source.
• The assumptions made in preparing the financing plan, together with electronic copies of the financial models, should be retained in the division files for later use in PCRs or PPARs.

Financial Projections:
Revenue Generating Projects:
For revenue generating projects, projected balance sheet, income statement and cash flow statement should be prepared. The following approach is recommended:

• Financial projections should be prepared in domestic currency units with foreign currency items (i.e. foreign currency denominated debt, foreign currency costs for imported materials etc) being translated into domestic currency units at the projected exchange rate.
• Purchasing power parity is the base assumption, with exchange rates expected to fluctuate in accordance with the formula provided above.
• The financial projections should be completed for the executing or implementing agency, not for the Project alone, unless the executing/implementing agency is a sole purpose entity (i.e. has been established for the sole purpose of the project).
• The financial statement presentation should be derived from the financial statement format used by the executing agency (following the EA's existing chart of accounts) when possible, provided these formats provide sufficient information.
• The financial projections should use the last audited financial statements for opening balance sheet assumptions.
• A risk assessment should identify those cost and revenue elements subject to uncertainty and/or those amounts significant enough that a change to them could materially affect the financial projections.
• Key risks and/or significant items should be modeled and assumptions noted in the model documentation and financial appendix or supplementary appendix of the RRP.
• Income statement (tariff assumptions, cost assumptions etc), balance sheet (asset capitalization, depreciation, accounts receivable etc) and cash flow (collections, debt service etc) assumptions should be considered.
• Basic assumptions should be consistent with those used for economic analysis.
• Financial models should be constructed such that income statement, balance sheet and cash flow statements are integrated statement.
• Financial projections should be completed for a minimum of 5 years (maximum of 10 years, after the end of construction), not the duration of the ADB loan.
• Summary historical financial statements should be presented, as an appendix to the RRP, together with financial projections for the implementation period and three-five years post implementation operations. Detailed financial projections, together with key assumptions, may be provided in a supplementary appendix.
• The assumptions made in preparing the financial projections, together with electronic copies of the financial models, should be retained in the division files for later use in PCRs and PPARs.

Non-Revenue Generating Projects:
While full financial statement projections may not be relevant for non-revenue generating projects, the following approach is recommended:

• Financial projections should be prepared for recurring costs (operating costs, maintenance costs, salaries, supplies etc)
• The budget position of the borrower should be reviewed to determine the potential impact of recurrent cost on the overall financial position
• If the executing agency does not have sufficient resources to cover recurring costs, assurances should be sought for additional transfers from the national budget to support the shortfall
• In those cases where funds have been established to support ongoing operating and maintenance costs (for example, road funds), then a cash flow projection (revenue and expenses) should be completed for the fund and assurances sought that either user charges will be increased and/or budget transfers will be provided to meet projected cash shortfalls.
• The projected recurrent costs, and/or cash flow projections should be included in the financial appendix of the RRP. Detailed financial analysis could be provided as a supplementary appendix.
• The assumptions made in preparing the financial projections, together with copies of the financial models, should be retained in the division files.

Ratio Analysis:
In addition to financial projections, key operating and financial ratios as appropriate to the sector should be computed over the duration of the financial projections. In addition, operating ratios (specific to the project and sector) should be considered. Key ratios should be incorporated into loan covenants and should be monitored throughout project implementation.

Financial Internal Rate of Return (FIRR):
The FIRR should be computed for all revenue generating projects. The FIRR measures the expected financial benefits of a project. The following approach is recommended for the computation of FIRR:

• The FIRR is computed on an after tax basis in real terms. The nominal financial cash flow is converted to real terms by removing the impacts of inflation and potential currency fluctuation.
• Interest and other financing charges during construction should be removed from costs, as these relate to the capital structure, or the financing decision, rather than to the investment decision. FIRR attempts to measure whether or not the investment is appropriate not on whether or not the financing structure is appropriate.
• The FIRR is computed on an incremental "with" versus "without" project basis. In other words, in the absence of the project, the income statement, balance sheet and cash flow assumptions may be different from under the "with" scenario. For example, without the investment proposed under the project, the entity may incur higher operating costs, earn lower incomes or invest in alternative projects.
• The FIRR should be computed over a realistic useful life of the assets, not necessarily over the term of ADB's loan. In most cases, FIRRs computed over a 15-year period after project completion would be reasonable.
• Should the assets be deemed to have a residual value in the last year covered by the FIRR computation, that residual value should be included as a financial benefit.
• The FIRR and the Economic Internal Rate of Return (EIRR) should be computed over the same period of time.
• The assumptions used to compute the FIRR, together with a table indicating how the FIRR was computed, should be provided in the financial evaluation appendix to the RRP.
• An electronic copy of the financial model used to compute the FIRR should be retained in the division files for later use in PCRs and PPARs.

Weighted Average Cost of Capital (WACC):
The WACC measures the expected financial costs associated with financing the project. The following approach is recommended for the computation of the WACC:

• The WACC is computed on an after tax basis in real terms. The nominal financial cash flow is converted to real terms by removing the impacts of inflation and potential currency fluctuation.
• Interest payments are to be adjusted to take into account tax savings realized (as interest payments are tax deductible items in most jurisdictions).

Cost of Debt:
A cost of debt should be computed for each source of debt (domestic currency denominated debt, ADB debt, co-financed debt etc).

• Cost of debt should include interest, service charges, commitment fees and front-end fees as applicable.
• Cost of debt should be based on the face value interest rate of the debt instrument, for example, the bond coupon rate or the interest rate applicable to a particular loan.
• If the interest rate is a variable (versus fixed interest rate), as is the case with ADB's Libor Based Loan products, the applicable 10 year fixed swap rate should be used plus a provision for ADB's spread of .6%.
• The cost of debt should be adjusted to reflect the impact of income taxes by multiplying the interest rate by (1-tax rate).
• The nominal cost of debt is converted to the real cost of debt is by applying the following formula:

CD r = [(1+CDn) /(1+AI)-1]

where: CDr - after tax cost of debt in real terms
CDn - after tax cost of debt in nominal terms
AI - average applicable inflation rate

Domestic average inflation rate should be used for debt denominated in domestic currency units, while international inflation rates should be used for foreign currency denominated debt. Inflation rates to be used are computed annually by ERD and posted on the intranet.

Cost of Equity:
Cost of equity is more difficult to compute. In theory it represents the opportunity cost of investing in the project. The most appropriate cost of equity would be the Government's economic cost of capital. However, in most cases, the economic cost of capital is difficult to determine.

• The cost of equity should reflect the Government's cost of raising capital, the tenure of the investment and the risks associated with the project.
• One approach to establishing a cost of equity would be to consider the Government's long-term bond rate (presuming bonds are issued and are deemed to be risk free), adjusted upward to reflect the term (i.e. bonds are often issued for 5-15 years, project investments tend to cover a longer period), and then adjusted upward to reflect project risks.
• Another approach would be to consider the desired rate of return for an equally risky venture were it to be financed through the private sector. The Capital Asset Pricing Model provides a methodology for this computation, however, emerging markets may be relatively small and underdeveloped. Determination of an appropriate beta coefficient and market premiums may be problematic. In the absence of such a beta, one approach would be to use a USA beta or betas for other neighboring countries (such as Thailand, India etc) for the relevant sector and adjust upwards to reflect country and project risk. The formula to be applied is:

Nominal Cost of Equity = Rf + B * (RPm) + RPo

Where: Rf is the risk free interest rate (i.e. government treasury bills)
B is the equity beta
RPm is the market risk premium
RPo reflect other premiums as necessary to reflect project specific risks.

• The nominal cost of equity should be converted to real cost of equity as noted above.
• Irrespective of the methodology applied, the rationale for the cost of equity should be noted in the financial evaluation appendix of the RRP.

Weighting:
The WACC is computed by weighting the cost of each element in the financing plan by its proportionate contribution to overall project financing.

• The assumptions used in computing WACC, and the associated computation, should be included in the Financial Evaluation appendix of the RRP.

Financial Evaluation and Sensitivity Analysis:
The financial evaluation of ADB's investment projects consists of a comparison between the FIRR (representing financial benefits) and the WACC (representing financial costs). If the FIRR exceeds the WACC the project is deemed to be financially viable. It should be noted that financial sustainability also requires a net positive cash flow throughout the project operating life.

• The FIRR, WACC and key financial and operating ratios should be subjected to sensitivity analysis. The actual scenarios to be tested should be based on key project risks. Common scenarios include: (i) project cost overrun; (ii) implementation delays; (iii) revenue performance lower than projected; (iv) expenditures higher than projected; and (v) and other project specific sensitivities. Combinations of likely impacts (for example an implementation delay automatically increases project costs) should also be considered where relevant. Should floating interest rate debt be obtained (for example ADB's libor based loan product), it may also be prudent to test for extreme variations in the cost of long term debt.
• It should be noted that the WACC will remain constant under most scenarios with the exception of those resulting in either a cost overrun or construction delay. In the case of an overrun, an assumption with respect to financing the excess cost will be required as ADB does not finance overruns.
• The RRP should clearly state the basic assumptions under which the financial evaluation was undertaken, a summary of sensitivity analysis and a statement with respect to project viability as indicated in the following example:

"The financial evaluation of the Project was undertaken in real terms using constant 200X prices. The project cost estimates and financial projections in nominal terms were converted to real terms by adjusting for the projected effects of foreign and domestic inflation and currency fluctuation. Incremental costs and benefits were derived by evaluating the financial position of the executing agency under with- and with-out project scenarios. The financial internal rate of return (FIRR) for the Project, computed on an after-tax basis, is x.x percent. This compares favorably with the weighted average cost of capital (WACC), also computed on an after tax basis, of y.y percent. The Project is considered both financially viable and sustainable. Sensitivity and risk analysis indicates that the FIRR is robust under adverse conditions. The analysis is summarized in Table x, a more detailed financial evaluation is provided in Appendix y."

3.4.2; 3.4.1.3;
3.4.3.5








3.4.4.4.1









3.4.4.2

3.4.4.3




3.4.3.4.1































4.3.6.1.5
3.4.7.5




















4.3.6.5.1; 3.7.3.6.3


4.3.6.1.4
3.4.7.6




















3.4.7.1

4.3.5.2.4










4.3.6.5.3













4.3.6.5.3



4.4.6





3.5.2.1.1; 3.5.3.1


3.5.2.2.2
























3.5.2.2.1


3.5.2.2.2


3.5.2.2.2


3.5.2.2.2


























3.5.2.2.2































3.5.2.2.2






3.5.3.4





3.5.3.4

7.11; 3.5.4

Executing Agency/Project Implementing Agency:
For revenue generating projects, ADB requires a general purpose audit report covering the audited financial statements (AFS) for each executing agency and/or project implementation agency associated with the project, together with a management letter, by agency. The financial statements should be prepared and the audit conducted in accordance with accounting and auditing standards acceptable to ADB. International Financial Reporting Standards (currently referred to as International Accounting Standards) and International Standards on Auditing are used as benchmarks in determining whether or not standards are acceptable to ADB.

Project Accounts:
ADB requires a special purpose audit of project accounts. The engagement letter (issued by the EA/borrower to the external auditor) for the special purpose audit should lay down the coverage of the audit and nature of the audit opinion required including statements with respect to:

• scope of special purpose audit report and its use (including standards under which it was prepared) including period covered
• the accounting standards under which the financial statements were presented
• the standards under which the audit was conducted
• audit opinion covering current and cumulative project activity including how any outstanding audit observations have been dealt with
• compliance with financial covenants in the loan and project agreements
• the application of ADB's funds and that they have been used for their intended purpose

Management Letter:
In those cases where a management letter is not received for the entity as a whole, then a management letter covering internal controls and procedures associated with preparation of project accounts is required and should be submitted together with the audited project accounts (APA).

SOE/Imprest Account: If a SOE and/or Imprest fund facility has been provided, the special purpose audit should include a separate opinion on (i) utilization of the imprest account; (ii) statement of expenditures including whether amount claimed was duly supported to the extent verified; and (iii) whether or not the EA was operating the imprest account in accordance with ADB's procedures.

Unaudited/Draft Financial Statements:
Submission of unaudited/draft financial statement may be requested but should not be used to determine compliance with loan and/or project agreement covenants.

Reporting Deadlines:
Audited financial statements (for the EA, project accounts, and imprest fund as applicable) should be submitted to ADB not more than 6 months following the end of the fiscal year or project closing date (whichever comes first). This reporting period could be extended to 9 months, for the following exceptions:

• In cases of weak institutional capacity, submission of AFS/APA can be started at nine (9) months and later be reduced to six (6) months over the course of project implementation.
• In cases of decentralization, the deadline could be extended up to nine (9) months if logistical considerations are such that they would impact the physical flow of information.
• As State-Owned Enterprises (SOEs) are expected to behave as a corporate entity, and to operate on commercial principles, no exceptions beyond six (6) months should be considered for submission of audited financial statements and project accounts.

5.4.2.1
5.6.10.1


5.2.3; 5.4.2.1;
5.6.1.1




FM Addendum p. 43





5.6.2.9
5.6.2.2.



5.6.4








5.6.9; 5.4.3.10;
FM Addendum p.43



5.3.2.9