At some point in time, many companies will be required to make funding decisions regarding specific projects. Is it better to put your resources here, or there? Incremental cash flow analysis can help you work out the additional cash flow generated by new projects, enabling you to determine with greater accuracy where to invest your capital. Find out everything you need to know about incremental cash flow, including how to calculate incremental cash flow, right here.
Incremental cash flow explained
So, what are incremental cash flows? Essentially, incremental cash flow refers to cash flow that a company acquires when it takes on a new project. If you have a positive incremental cash flow, it means that your company’s cash flow will increase after you accept it. That’s a good indicator that it’s worth investing in a project. On the other hand, a negative incremental cash flow indicates that your cash flow will decrease, which means that it may not be the best option.
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
Incremental cash flow example
It’s always useful to look at an incremental cash flow example to see how this process works in real life. Imagine Company A wants to develop a new product and is looking at two different options: Product 1 and Product 2. Incremental cash flow analysis is a great way for Company A to determine which option to go into production with.
Product 1 is projected to have revenues of $200,000, expenses of $90,000, and an initial cash outlay of $15,000. By contrast, Product 2 is expected to bring in revenues of $500,000, but will require expenses of $350,000 and initial costs of $65,000
Product 1 ICF = 200,000 – 90,000 – 15,000 = $95,000
Product 2 ICF = 500,000 – 350,000 – 65,000 = $85,000
As you can see, although the projected revenues of Product 1 are substantially lower than those of Product 2, the resulting incremental cash flow is $10,000 more because Product 2 has higher expenses, as well as a more significant cash outlay. Using incremental cash flow analysis, Company A can determine that Product 1 is the better option.
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 the incremental cash flow formula
Although incremental cash flow analysis seems effective, there are numerous limitations that you should consider. Most importantly, many of the variables affecting incremental cash flow are difficult to project. For example, market conditions and regulatory changes can have a significant effect on expenses. It’s also important to remember that sunk costs (past costs that have already been incurred) shouldn’t be included in your analysis, particularly if the sunk cost happened before your company decided to invest.
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