The distinction between economic analysis and financial analysis is not always straightforward. In this post I try to clarify this.
I have previously defined WASH economics as “the study of how people make decisions about the allocation of scarce resources in the delivery and use of WASH services.” See that post for more discussion of definitions.
In turn, my working definition of WASH finance is “the study of how WASH services are paid for, including who pays, how and when”. More on this definition another time. Within the realm of “finance” it is important to distinguish between funding and financing, as is now becoming the norm. In a recent book chapter on equality in WASH funding and financing I co-authored with Richard Franceys, we explain this as follows:
“Funding is broadly defined as providing money which is not expected to be repaid. In the WASH context, funding usually comes from three sources: tariffs (including self-supply expenditure or user charges such as connection fees), government tax revenue, and donor transfers. Together, these are known as the “3Ts” framework, popularised by the OECD. In contrast, financing, is defined as providing money as a loan or equity in the expectation that it will be returned in full and with interest, in the case of debt, or dividends from profits, in the case of equity. In other words, funding is the provision of non-repayable money and financing is the provision of money which is repayable to the financiers.”
Turning to economic and financial analysis, I would characterise that as technical work which uses the perspective and methods of those two disciplines to appraise plans, projects and investments. The reason I emphasised the phrase “paid for” in the above definition of WASH finance is that it brings out the difference between economic and financial costs.
Economics costs vs. financial costs
Economic costs are the opportunity cost of resources (i.e. the value of the highest-value alternative use). Financial costs, meanwhile, are resources that are “paid for” (a turn of phrase borrowed from the health sector).
Not all resources used in the delivery of WASH interventions and programmes are paid for. Consider unpaid household time in programme participation or toilet construction, and the use of an asset that is donated to the programme, such as a vacuum truck. An estimate of the value of each of these resources would be excluded from a financial analysis but included in an economic analysis. This is because economic analyses should assess opportunity costs (defined above).
Underlying this is issue of valuation, i.e. what are things worth? Theories of value have been debated in economics since the discipline began. Financial costs are normally straightforwardly valued at the price paid. The complicated part is how to spread them over time – the financial cost of a programme in a given year is rarely the same as programme expenditure in that year.
Valuation of economic costs, however, is more tricky. There can be many competing ways to value an opportunity cost. For example, the opportunity cost of a person’s unpaid time in undertaking unskilled labour might be taken as (i) the minimum wage rate in that country for unskilled labour, (ii) 50% of that (reflecting the fact that the time may not have been allocated to income‐generating activity), or (iii) some other assumption based on another wage rate local to the setting (if the minimum wage is not a good reflection of market wages). The opportunity cost of a donated vacuum truck might be its estimated resale value in the open market. So, the total economic cost of a programme or intervention is the value forgone of all resources used.
Financial analysis implies the perspective of a given payer, whereas economic analysis usually (but not always) implies a societal perspective. So, economic evaluations (such as those employing cost-benefit or cost-effectiveness analysis) usually take a societal perspective. Planning and budgeting exercises, meanwhile, usually take the perspective of the institution that will pay for the programme of service. For example, the budget for an NGO’s rural water programme would only include the financial costs that would pass through their books. It would not include financial costs borne other stakeholders partners (such as local governments or households) covered from other revenue sources.
Types of economic and financial analysis
There are many types of economic and financial analysis. All require cost analysis. Going into them is beyond the scope of this post. In brief, economic analysis is primarily concerned with efficiency (whether technical, productive or allocative) so includes things like economic evaluation (cost-benefit, cost-effectiveness), damage cost assessment, etc. but also assessment of economy and input/output relationships. Altogether, most of these things are part of Value for Money analysis (see diagram on p.5 of this). Financial analysis, meanwhile, includes things like funding gap analysis, cashflow analysis, willingness to pay assessment etc. – note the focus on covering costs, rather than on assessing efficiency.
The table below uses a few examples to illustrate some important of the purposes, and how the purpose drives the analytical perspective and type of cost used. More on this another time.
My short (and perhaps flippant) summary of the difference between economics and finance is that “economics is about valuing stuff” and “finance is about who pays, how and when”. When considering an investment, both economic and financial analysis are important. In addition to knowing whether a project will have net benefits (i.e. is worth doing), it is important to know that it will be financially sustainable (i.e. the life-cycle costs can be covered).