Incremental cash flow refers to the additional operating cash flow that an organization receives from undertaking a new project. A positive incremental cash flow signifies an increase in the company’s cash flow when a project is accepted and is a good indication that an investment is worthwhile.
Key Takeaways
- Incremental cash flow represents the potential change in a company’s cash flow due to a new project or investment.
- A positive incremental cash flow indicates that the investment is more profitable than the costs incurred.
- It is a useful tool for assessing new ventures, but it should not be the sole criterion for decision-making.
Understanding Incremental Cash Flow
When examining incremental cash flows, several important components must be identified: the initial outlay, cash flows from undertaking the project, terminal cost or value, and project scale and timing. Incremental cash flow is essentially the net cash flow derived from all cash inflows and outflows over a specified time period between multiple business choices.
For example, a company might project the net effects on the cash flow statement of investing in a new business line or expanding an existing one. Choosing the project with the highest incremental cash flow may be more beneficial. These projections are required for calculating a project’s net present value (NPV), internal rate of return (IRR), and payback period. Additionally, forecasting incremental cash flows can inform decisions about investing in new assets that will be reflected on the balance sheet.
Example of Incremental Cash Flow
Consider a scenario where a business is looking to develop a new product line and has two options: Line A and Line B. Over the next year, Line A is projected to generate revenues of $200,000 with expenses of $50,000. Line B is expected to generate revenues of $325,000 and incur expenses amounting to $190,000. Line A requires an initial cash outlay of $35,000, whereas Line B requires $25,000.
To calculate each project’s net incremental cash flow for the first year:
$$ ICF = Revenues - Expenses - Initial Cost $$
For each project, the calculations are:
- Line A Incremental Cash Flow (LA ICF): $$ LA ICF = $200,000 - $50,000 - $35,000 = $115,000 $$
- Line B Incremental Cash Flow (LB ICF): $$ LB ICF = $325,000 - $190,000 - $25,000 = $110,000 $$
Even though Line B generates more revenue, its resulting incremental cash flow is $5,000 less than Line A’s due to higher expenses and initial investment. If incremental cash flow is the sole determinant, Line A is the better investment option.
Limitations of Incremental Cash Flow
While the example above highlights the concept, projecting incremental cash flows can be very challenging in reality. Various internal and external variables—such as market conditions, regulatory policies, and legal changes—affect incremental cash flow and can be unpredictable. Another hurdle is differentiating between cash flows from the specific project and general business operations, which can result in inaccurate selection if not properly identified.
Related Terms: cash flow, net present value (NPV), internal rate of return (IRR), expenses, revenue
