Are you for Real?!

By Nick Crawley on May 6 2009

The age old question in preparing a financial model is whether or not to do so on a real or nominal basis - and it is still going! In a nutshell, real is where economic inflation, such as CPI and labour growth indices are not factored into analysis and nominal is when they are.

Why prepare financial analysis on a ‘real’ basis?

Many industries, in particular natural resource developers, such as mining and oil companies, do perform real analysis as standard. They appear to do this for many reasons, some more valid than others, the ones I hear frequently are:

“Inflation adds an unnecessary element of uncertainty”
“There are already enough assumptions in the model lets not add more”
“Commodity prices are not indexed to CPI so lets prepare costs on the same basis”
“In many industries real costs trend down so adding inflation would mask this”
“Short term cashflows are not impacted by inflation”
“I have captured the real growth rates, that’s all I need to worry about”
“In today’s money, projected cashflows are what we would expect to see”
“I want to use Purchase Power Parity to calculate the interest rate”

The arguments for a nominal approach to financial analysis.

All of the reasons above are to the people that made them, quite valid, but I think consideration should be paid to the benefits of including at least the mechanism for inflationary assumptions to be entered.

This is why you need to include inflation assumptions (even if they are zero).

It is then very clear the basis of your analysis
A lender will generally require inflation into its credit analysis so it makes sense to provide for it
A banks interest rate will be provided on a nominal rather than a real basis
If you do not include realistic inflation assumptions your tax calculation will be wrong
Many funds benchmark based on Post Tax, Nominal returns, therefore both tax and inflation need to be as realistic as possible.

My view is that inflation is generally not zero so why make that assumption inherent? If your own way of analysing projects is to do it on a real basis then maybe consider achieving this by incorporating an inflation mechanism but setting it to zero - that way most users requirements will be met and that’s one of the key characteristics of a good project financial model. Either way in the same way every line item needs to have a description and a unit of measure, ensure it is also clear if it is real or nominal - ignoring this has lead in recent times to one of the largest errors ever discovered in a financial model (post winning the bid - ouch!!)