Incremental cash flow isn’t a term you regularly hear unless you’re getting deep into your business’s accounting. But it’s a crucial piece of information that you should consider any time you take on order.
Incremental cash flows are the net additional cash flows generated by a company by undertaking a project. Capital budgeting decisions are based on a comparison of a project’s initial investment outlay to the future incremental cash flows of the project and its terminal cash flow.
What is incremental cash flow?
Incremental cash flow is an additional operating cash flow that a company earns when accepting a new project. If an organization has a positive incremental cash flow, they’re more likely to increase the amount of overall cash flow if they work on new projects. A company can work on new projects if they sign new clients or take on a new project with an existing client.
Overall cash flow refers to the amount of money transferred inside and outside of the business. Cash flow is important for a business because companies can track whether they have enough money to pay expenses, loans, and taxes, and buy assets to improve business operations.
Many factors affect a company’s incremental cash flow, including:
- Market trends
- Changes in regulations
- Adjustments to company and legal policies
- Modifications of cash flow from projects and business operations
Overview of Incremental Cash Flow
Incremental cash flow analysis is used to review a change in the cash inflows and outflows that are specifically attributed to a management decision. As an example, if a business is considering altering the amount of production capacity of a machine, the decision should be made based on the incremental cash outflows required to alter the capacity of the equipment, as well as the incremental cash inflows resulting from that decision. There is no need to consider the aggregate cash flows associated with all operations of the machine.
The analysis may be based on a variety of cash flows, such as the initial outlay of cash, ongoing inflows and outflows related to the maintenance, operations, and net receipts from the project, and any cash flows associated with the eventual termination of the project (which includes both cash inflows from the sale of the equipment and cash outflows for remediation costs).
This type of analysis can be manipulated. A manager who wants to have a project approved could make adjustments to forecasted cash flow levels to de-emphasize cash outflows, while over-estimating cash inflows. These adjustments may only be noted years later after sufficient actual results have been experienced to yield a valid comparison to the original forecast.
The Three Components of Incremental Cash Flow
The three components that make up incremental cash flow are the initial investment, the operating cash flows, and the terminal cash flow.
We will explain each of these.
The initial investment consists of the amount of money needed to start or set up a business or project.
For example, if a bakery wanted to start selling coffee, all of the equipment necessary to start selling coffee would be part of the initial investment.
This would include items such as a grinder, drip coffee machine, espresso machine, milk, and even the first bag of coffee.
None of the money already spent on the bakery would be included even if it will be used for the coffee part of the business because these are sunk costs.
Operating Cash Flow
The operating cash flow is the cash that is expected to be generated by the business or project.
In the case of our coffee shop example, this would be the cash made from selling the coffee after subtracting the raw materials and expenses.
This would be the coffee beans as well as expenses such as the electricity to run the coffee machines and the labor to make and serve the coffee, among others.
Terminal Cash Flow
The terminal cash flow for a project would be the net cash flow received when a project ends, and the business disposes of any assets used in the project.
For the coffee shop, this would mean any money received from selling the assets that were used for the coffee part of the bakery business after any expenses associated with the project are subtracted.
Incremental cash flow consists of the net cash flow between projects, which is the cash inflow minus the cash outflow for a certain period of time.
There are also other similar methods that could be used to assist management in making budgeting decisions, such as net present value (NPV) or internal rate of return (IRR).
Incremental Cash Flows Example
ABC is considering investing in new machinery which costs $ 500,000. It has a useful life of 5 years with a scrap value of $ 50,000. Based on the projection, the company will be able to increase its sale by $ 1 million per year with 40% of variable cost.
What are the incremental cash flows of this project?
The cash inflow over the project is $ 5,000,000 ( $ 1,000,0000 * 5 years)
The cash outflow over the project is $ 2,000,000 (40% of the sale is variable cost)
ICF =$ 5,00,000 – $ 2,000,000 – $ 500,000 = $ 2,500,000
How to calculate incremental cash flow
Think that incremental cash flow analysis could be useful for your business? Learning how to calculate incremental cash flow is relatively straightforward. You just need to know a couple of basic pieces of information about your business’s finances. Then, you can use the following incremental cash flow formula:
Incremental Cash Flow = Revenues – Expenses – Initial Cost
Advantages of incremental cash flow analysis
Incremental cash flow analysis can be an excellent tool for businesses that need to decide whether to invest in certain assets. If you have a cash surplus and can’t work out whether it’s a better idea to expand an existing product line or invest in a new one, whichever option has the highest incremental cash flow may be your best bet.
Limitations of Incremental Cash Flow
The simple example above explains the idea, but in practice, incremental cash flows are extremely difficult to project. Besides the potential variables within a business that could affect incremental cash flows, many external variables are difficult or impossible to project.
Market conditions, regulatory policies, and legal policies may impact incremental cash flow in unpredictable and unexpected ways. Another challenge is distinguishing between cash flows from the project and cash flows from other business operations. Without proper distinction, project selection can be made based on inaccurate or flawed data.
Incremental Cash Flow vs. Total Cash Flow
Incremental cash flow and total cash flow both deal with a business or project’s cash flow. However, they are notably different from each other.
- Incremental cash flow analysis tries to predict the future cash flow of a business if it takes on a new project. It helps management determine if a project is worth doing or not. Projects will be considered if it is a positive incremental cash flow is generated and declined if negative cash flows are expected.
- Total cash flow analysis determines the total cumulative cash that’s been generated from doing a project or evaluating a business. For example, when a CEO wants to see the total cash flow of the company from each of the preceding five years. To come up with the correct figure, all the cash flows from each year in the last five years are put together.