C9.2.3.1 Economic analysis versus Financial analysis
Financial and economic analyses have similar features. Both estimate the net-benefits of a project investment based on the difference between the with-project and the without-project situations.
The basic difference between them is that:
- the financial analysis compares benefits and costs to the enterprise, while
- the economic analysis compares the benefits and costs to the whole economy.
Economic analysis is concerned with the true value a project holds for the society as a whole. It subsumes all members of society, and measures the project’s positive and negative impacts. In addition, economic analysis would also cover costs and benefits of goods and services that are not sold in the market and therefore have no market price.
There are two more significant differences between financial and economic analysis:
- While financial analysis uses market prices to check the balance of investment and the sustainability of a project, economic analysis uses economic prices that are converted from the market price by excluding tax, profit, subsidy, etc. to measure the legitimacy of using national resources to certain projects.
- Financial and economic analyses also differ in their treatment of external effects (benefits and costs), such as favourable effects on health. Economic analysis attempts to value such externalities in order to reflect the true cost and value to the society. The inclusion of externalities raises difficult questions of their identification and measurement in terms of money.
It should to be noted that economic and financial analysis are also complementary. For a project to be economically viable, it must be financially sustainable. If a project is not financially sustainable, there will be no adequate funds to properly operate, maintain and replace assets.