Cash Flow Management in Large Infrastructure Projects
Mr. Asim Prasad, chief manager, GAIL (India) Limited outlines a methodology to plan and manage capital expenditure in large projects
Large infrastructure projects are capital intensive, have long gestation periods and require huge capital for successful completion. A large number of infrastructure projects are being undertaken in India to speed up development. Most of these projects are executed amid challenges that are beyond the control of the project executing agencies. Such challenges lead to risks, which if not identified and managed properly, result in time and cost overrun.
A large infrastructure project is seldom executed on equity capital alone. The cost of capital decides the cost at which the end-user will finally avail services after the project’s commercial operation starts. Since most projects involve both equity and debt, managing cash outflows efficiently is a difficult and intricate process. In this article, I submit a methodology that I have conceptualized and applied successfully in the capital expenditure planning of natural gas pipeline projects.
Challenges in Large Projects
The challenge before a project manager of a large infrastructure project is to precisely forecast the amount and timing of capital expenditure outflow. Efficiency in managing this process reduces the interest on the capital employed. The methodology involves estimating the cost of different packages, predicting the timing of cash outflow, securing funds on time, controlling and monitoring the actual cash outflow, identifying deviations in the cash flow plan, and modifying the baseline plan periodically to synchronize it with the incremental physical progresses so that the actual cash outflow is within permissible deviation limits. This is a continuous and intricate process as it requires thorough knowledge of schedule and actual progress, commercial purchase and work order conditions, schedule for raising bills, anticipated amount against each bill, and processing time before payment release.
Cash flow management needs to adapt to the changing environment quickly. It has to ensure that sufficient funds are readily available to make payments against bills received, without affecting the delivery of goods and services.
Steps in Cash Flow Management
Cash flow management is an integral part of project management. It’s a systematic, long-drawn and continuous process that starts immediately after the project business case has been prepared. The cash flow management planning must start once the project charter is handed over to the project manager. The plan has to synchronize with the overall scheduled physical progress plan. Experience reveals that the overall percentage planned cash outflow lags behind the overall percentage scheduled physical progress. This is due to the fact that payments are made only after completion of work or delivery of material and services by contractors and vendors. Estimating the net cash flow over the economic life of the project with accuracy is important as it affects the shareholders’ profits during the project’s commercial operation. Based on my experience, the steps required for efficient cash flow management for large infrastructure projects are detailed below:
1. Identification of cost heads:
Large infrastructure projects involve various cost heads comprising direct, indirect, hard, and soft costs. Soft costs are extraneous costs that are not foreseen at the time of project formulation and hard costs are the actual purchase price. The project cost estimated at the time of project investment approval is the cost considered in the Detailed Feasibility Report (DFR). This forms the basis for ascertaining deviations at the time of project completion.
2. Estimation of cost against each item in the cost head:
During the project investment approval, costs inclusive of taxes and duties, are allocated against each item under the cost head. Based on the experience of executing similar projects, market estimates and cost database, cost of some of the items could be in foreign currency. With changes in market conditions, a 20 percent deviation from DFR is reasonable. Commonly encountered cost head items in these projects are:
3. Calculate the cash outflow based on DFR cost and anticipated project schedule for each item:
- Land, survey and statutory permissions
- Procurement packages such as raw materials, equipment, and machinery
- Work packages for different types of specialized contract works
- Project management consultancy and third-party inspection services
- Owners’ management expenses such as wages, salary, lodging and boarding of workers, setting up offices, and establishing communication networks
- Contingency or management reserve for managing known and unknown risks
- Inflation, interest, margin money for working capital, and foreign exchange variation
Infrastructure projects take 3-5 years to complete. At the time of project investment approval, the physical progress schedule of the project is prepared. This schedule is based on a forecast of how the project is likely to progress each month. The project manager then forecasts expenditure against each item such as estimated project progress schedule, bills schedule by vendors/contractors, time taken to process these bills and anticipated bill amounts. The project manager now has the incremental and total planned expenditure against each month. He/she can also ascertain the cumulative cash flow in each month as a fraction of approved project cost.
4. Calculate the cash outflow for each item based on actual ordered value and planned incremental scheduled progress:
Since orders are often placed at a date later than planned, the actual order value might differ from the DFR estimate. Delays are common because high value procurement has lengthy processes with multiple stakeholders. Hence, it is important to record the actual order value against each item. Next the project manager calculates the planned expenditure against each item and the total incremental planned expenditure against each month. This method helps in deriving the cash flow.
Expenditure against contingency, inflation, interest, margin money for working capital, and foreign exchange variation is recorded during project capitalization on actual basis.
5. Recalculate the cash outflow during project execution based on balance expenditure and actual progress:
Infrastructure projects encounter hurdles due to political, economic, social, technical, legal, and environmental factors. Therefore, the actual percentage progress varies from the scheduled percentage progress, which directly affects the actual expenditure outflow. The actual expenditure of a delayed project will be lesser than the planned expenditure.
In order to ascertain the planned cash outflow of successive months, calculate the balance expenditure at the end of the current month for all items. This balance expenditure is the difference between the actual order value and sum of the payments made for the items till the previous month. Based on the current progress and commercial order conditions, the balance expenditure is distributed in the subsequent months. This way, the forecasted cash outflow is calculated. This method results in realistic cash outflow against each item for all subsequent months. For orders placed on fixed cost basis, this monthly process stops when the total balance expenditure is zero, indicating that the entire committed expenditure has been made. However, in case the actual expenditure overshoots the DFR estimated cost, it means that the project encounters cost overrun.
6. Prepare contingency plan to minimize deviations:
The actual overall progress of large infrastructure projects in India is seldom ahead of schedule. The project team needs to prepare contingency plans for work breakdown schedule elements where actual progress is behind schedule. However, project execution involves scarce resources and the project manager may not always be at liberty to execute contingency plans. Project delays also result in cost overrun. While preparing contingency plans, the project manager needs to conduct a decision tree analysis to ascertain the cost of not implementing the contingency plan or implementing it partially due to scarcity of resources.
7. Continuously monitor the actual cash outflow:
Monitor the actual cash outflow continuously with the release of payments against running bills. This is a real-time process, which requires systems to monitor the progress electronically and update the project manager on aspects like availability and the cost of funds for capital expenditure, balance payment against each item on cost head, forecasting a cash flow plan for succeeding months, and the percentage of financial progress made in each cost head along with the overall percentage financial progress. The financial percentage progress report will give the project manager a clear idea of whether there are chances of cost overrun in the project.
This methodology has been implemented with a reasonable degree of accuracy while executing cross-country natural gas pipeline projects. Infrastructure projects are largely executed with borrowed funds and hence precise forecast of cash outflows on a monthly basis is important. This way only the incremental amount required for expenditure in the successive months is borrowed. The above methodology also helps to prepare capital expenditure budget estimates for the project during execution. Companies that execute infrastructure projects of varying size and complexity can also ascertain the cash flow of the organization’s entire project portfolio.
Cash flow management is as much an art as a skill. As the project matures, the project manager needs to leverage the knowledge gained in the preceding months with regards to cash outflows. A proactive approach works well. Globally, projects see a higher level of involvement by senior management when it comes to the allocation of capital, performance tracking, and risk management. The involvement of suppliers and contractors during periodic cash flow planning helps to make the cash flow management plan more robust and versatile. Project leaders need to ensure that monitoring of the cash flow management strategy takes place through the project lifecycle and not just during the design and planning phases.
(Mr. Asim Prasad, B.Tech, Indian Institute of Technology, Kanpur, is chief manager at GAIL (India) Limited, New Delhi. He has rich experience in the natural gas value chain, comprising operation and maintenance of cross-country pipelines, project management, and natural gas marketing.)