Incremental Cash Flow: Definition, Formula, and Examples

Companies are required to make financial decisions for various projects at any given point in time. To identify where to put your resources can be a challenging task. However, incremental cash flow analysis can help solve your problems. You can find out additional cash flows generated by new projects to invest your funds. With this blog, you can find out everything you need to know about the what is incremental cash flow, how to calculate it, and more. 

What is Incremental Cash Flow?

Incremental cash flow (ICF) is the additional cash flow a company gets when it acquires a new project. Before we venture further, let’s understand what cash flow is and its definition. Cash flow is defined as the movement of money in and out of the company over a given time over a specific period. 

When the cash flow of a company increases it indicates a positive incremental cash flow which is a good indicator that the project is worthwhile. If the cash flow decreases then the company has a negative incremental cash flow and should re-evaluate the project they wish to undertake. 

Understanding Incremental Cash Flow 

Several factors need to be considered when analyzing incremental cash flows such as the initial cash outlay, cash flows, terminal cost, and the project’s size and timeframe.

This metric is required to calculate a project’s net present value (NPV), internal rate of return (IRR), and payback period. Analyzing ICF is extremely essential when deciding to invest in certain projects. 

While it is essential to analyze which projects a company should undertake, it should not be the only resource to assess them.

How to Calculate Incremental Cash Flow?

Incremental cash flow can be calculated easily and is vital for businesses to make sound decisions about their investments and projects. To calculate it, one can start by identifying the company’s investment costs. 

Next, you need to estimate the additional revenue the project will generate while taking into account any increase in operating expenses. Once you have these two pieces of information, you need to subtract them from the revenue to identify the net income. Make sure to consider the changes to your working capital and other tax implications. 

Finally, add your non-cash expenses such as depreciation back to your net income. Let’s take a look at the formula —

Incremental Cash Flow = (Revenue – Expenses) + Depreciation – Initial Cost

Example of Incremental Cash Flow

Let us assume that XYZ. Inc. is interested in developing a new cosmetic product line. The company has two alternatives – Line 1 and Line 2. 

In the next two years, Line 1 is projected to have revenues of $300,000 and expenses of $ 100,000 while Line 2 is expected to have revenue of $425,000 and expenses of $240,000. Line 1 would require an initial cash outlay of $30,000 and Line 2 requires $25,000. 

Now, let us calculate the project’s net incremental cash flow individually for both lines for the first year: 

Line 1 ICF = $300,000 – $100,00 – $30,000 = $170,000

Line 2 ICF = $425,000 – $240,000 – $25,000 = $160,000

From above, you can see that even though Line 2 generates more revenue than Line 1, its ICF is $10,000 less than Line 1 due to a larger expense than the initial investment. If the business is using only this metric to determine the viability of this 

Challenges in Determining Incremental Cash Flow?

Incremental cash flows are helpful when determining if a business should undertake a new project or not. However, there can be some difficulty in determining incremental cash flows. Let us take a look at some of the challenges one can encounter  —

1. Sunk Costs 

Sunk costs are past costs that have already been incurred whereas incremental cash flows look into future costs. While calculating incremental cash flows, one needs to ensure that sunk costs are included especially if they occurred before investing. 

2. Opportunity Costs 

The term opportunity costs means a company’s missed chance to generate revenue from its assets. They are often forgotten as they are not included during the computation of incremental cash flows. 

Let’s take a look at an example of  this. Suppose company ABC specializes in air conditioning installations and skips a project that requires the installation of four air conditioners. This means that there are four air conditioners sitting in their warehouse, instead of generating an income of $2000. This $2000 indicates the opportunity cost. 

3. Cannibalization

Cannibalization occurs when a company takes on a new project that in turn reduces the cash flow of another project or business. For example: a retail store that caters to luxury shoppers offers products at a premium price. 

However, the same retail store opens a new branch offering luxury products at an affordable price to customers other than luxury shoppers. This results in cannibalization since the same premium products are available at an affordable price, luxury shoppers might shop at the other location as opposed to the first one. 

4. Allocated Costs 

These are costs that are required to be set aside for a specific use department or project, for example, rent expenses and there might not be a rational way to do it.

What Are the Advantages of Incremental Cash Flow?

Incremental cash flow is an exceptional tool for companies to assess which projects to invest in. The advantages of are: 

• Decision-makers in a company can make informed financial decisions about their projects and assets. 

• Allows companies with multiple investment options to prioritize projects based on their cash flows. 

• Perform sensitivity analysis to understand how key assumptions of a project such as project duration, sales growth, discount, and more are affected. 

• Devise risk mitigation strategies to ensure that the projects are completed profitably. 

What Are the Limitations of Incremental Cash Flow?

While incremental cash flow analysis is effective in understanding which project will yield better outcomes, it is important to realize that there are certain limitations as well. Most variables associated with ICF are difficult to project. It is also dependent on market conditions, regulatory changes, sunk costs, and more which in turn have a remarkable effect on expenses. 

Calculate Incremental Cash Flow with CrossVal 

Identifying which project to invest in is a humongous task. There are a lot of factors to consider before choosing the right project for your company to undertake. 

CrossVal brings to life the next generation of financial modeling. You can now calculate incremental cash flow,  internal rate of return of incremental cash flow, make informed financial decisions, and more by using their intuitive strategic financial models in just under 4 minutes. 

Create your free account today to empower your company and make smart financial decisions 

Read more:

• All You Need To Know About FCF Conversion
• Difference Between Cash Flow Statement And Cash Budget
• Revised Quote Meaning: Simplified for Your Peace of Mind