Financial Analysis
Purpose of Cash Flows?
Having started my career as a financial analyst, I ran a lot of pro forma models and most were “static” one-pagers. And by static, we are generally talking about revenue and cost projections, but absent any timing assumptions. Thus, you would see the totals for various line items, and maybe a couple of columns that show the projections based on “per unit” or “per acre” for reference. But you would not have the timing, in terms of what month certain activities start and end, which months have revenue coming in, and which months have costs going out.
A cash flow model for the most part has all of the same line items as in a static model, but now you have months, quarters, or years showing how those totals occur over the life of a project. Years ago, the development of a cash flow projection was quite a bit more tedious to complete, and we would first start out with a static projection to get a feel for the project economics. At some point, though, we would go through the labor of creating the cash flow. Today, I think most homebuilders and developers have developed very sophisticated cash flow models and can generate a cash flow projection in not much more time than generating the static.
So what is the purpose and overall value of a cash flow projection that includes the timing assumptions? I would say there are many benefits, but the primary ones that come to mind are the evaluation of profit on a time-oriented basis, and the estimate of peak capital required. The cash flow can project your annual rates of return, such as IRR or return on investment. If you plan to make $5 million for profits, it will matter whether you earn that in three years versus six years. As for peak capital, let’s say you have total project costs of $40 million, but that does not necessarily mean you need capital of that amount. Because you have revenue coming in from home sales (again, timing assumptions needed!), the peak capital required might be in the neighborhood of $20 million. The cash flow will help analyze and understand this important number.
Other important benefits include more accurate estimates of costs that are based on time. One of the primary time-related costs is loan interest, which is based on how much debt is being carried on a month to month basis. Or other costs, such as on-site site supervision, temp facilities, model maintenance, and advertising are dependent the length and timing of the project. These costs can be estimated in the static pro forma, but the cash flow tries to perfect the estimate.
I worked for a large land developer who sold a lot of land to homebuilders. Our main goal was to estimate residual land value, and because we had a lot of internal data, our use of a static model tended to be more than adequate. But I am guessing that most all homebuilders run a cash flow model to make sure their estimates are fine-tuned, and that they truly understand the financial return on a time-oriented basis.
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