Home Business Accounting Incremental Cash Flow (Definition: What It Is And How It Works)

Incremental Cash Flow (Definition: What It Is And How It Works)

What is Incremental Cash Flow?

How does it work in business capital budgeting?

What are the essential elements you should know!

Keep reading as we have gathered exactly the information that you need!

Let’s dig into our accounting and business finance knowledge!

Are you ready?

Let’s get started!

What Is Incremental Cash Flow

An “incremental cash flow” is a finance and accounting term used to refer to the additional cash flow a company expects to receive (or have to disburse) on a specific project.

If the incremental cash flow is positive, it means that the company will see an incremental rise in its cash flows.

On the other hand, if the incremental cash flow is negative, it means that the firm expects to inject cash into the project.

As a result, if a project offers a company positive cash flow, it is a good sign that the project may be good for business.

Many companies use the “incremental” cash flow analysis to determine, at a high level, if the investment in a new project or asset may be worth it for the company.

Using the incremental cash flow analysis is not the only method of assessing the profitability or value of a new business venture but it’s a good starting point.

There are many factors that can affect a company’s incremental cash flow, such as:

  • Competitive landscape
  • Market trends
  • Regulatory landscape 

How Does Incremental Cash Flow Work

Let’s see how incremental cash flows work so we can better understand the concept.

In order to determine a cash flow a project or investment may provide a company, you must look at the following elements:

  • Initial cash outlay
  • Expected cash flows from the investment
  • Terminal cost 
  • Scale and timing of the investment

Essentially, what you are trying to assess is the net cash flow from incoming and outgoing cash during the life of the investment compared with other investment options or choices.

This way, if Investment A offers a higher incremental net income than Investment B, then Investment A should be favored.

Companies tend to assess the viability of an investment project by calculating a project’s net present value (NPV), internal rate of return (IRR), and payback period.

These are financial measures companies use to determine which investment option may be better than another or which asset may be a better acquisition for the company than another.

To calculate NPV, IRR, and the payback period, you will need to perform an incremental cash flow projection on the incremental cash you expect to receive or pay on a project.

Incremental Cash Flow Definition

According To the Corporate Finance Institute, an incremental cash flow is defined as follows:

Incremental cash flow refers to cash flow that is acquired by a company when it takes on a new project.
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In other words, a company can estimate a project’s impact on its cash flows by comparing their incremental cash flows.

If one business investment or activity provides a higher cash flow incrementally compared to another, it should be the project to favor.

Incremental Cash Flow Formula

You can use the following formula to calculate the cash flows you incrementally expect from different business investment options:

How do you calculate the incremental “cash flow”?

ICF = REV – EXP – ICO
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  • ICF = Incremental Cash Flow
  • REV = Revenues
  • EXP = Expenses 
  • ICO = Initial Cash Outlay 

How To Calculate Incremental Cash Flows

Now that you have the formula, let’s see what steps you need to take to calculate a company’s “incremental cash flows”.

Step 1: You should determine and estimate the company’s expected revenues by taking on a new project.

Step 2: Determine how much your company will need to spend to successfully bring the project to fruition.

Step 3: Determine how much money you need to spend upfront to kick-off the project.

Step 4: From the expected revenues, subtract your estimated expenses.

Step 5: From the number you get in Step 4, deduct your initial costs.

Incremental Cash Flow Examples 

Let’s look at an example of how ‘incremental cash flows’ work.

Let’s assume that a company has the option to invest in two different business projects.

Project A:

  • Anticipated revenues: $500,000
  • Anticipated expenses: $200,000
  • Initial investment capital outlay: $200,000

Project B:

  • Anticipated revenues: $200,000
  • Anticipated expenses: $25,000
  • Initial investment capital outlay: $25,000

By using the incremental cash flow formula, we could calculate the incremental cash flow for these two projects.

The formula is: Incremental Cash Flow (ICF) = Revenues (REV) – Expenses (EXP) – Initial Cash Outlay (ICO)

Let’s calculate the ICF for the two projects.

Project A: ICF = $500,000 – $200,000 – $200,000 = $100,000

Project B: ICF = $200,000 – $25,000 – $25,000 = $150,000

As you can see, Project A is expected to provide an ICF of $100,000 although requiring more cash whereas Project B has a higher expected ICF of $150,000 and will require less cash investment.

If a company would assess these two projects strictly based on ICF, then Project B should be selected.

Advantages And Limitations

Many businesses use the cash flow incremental analysis to quickly decide and get a rough idea on funding a business project, asset, or activity.

The rule of thumb is if the business activity, operation, investment, or asset purchased provides you with a more cash or cash surplus, then it’s a good project to consider.

Businesses can compare different lines of business, different products, and business operations to determine which business segment provides them with more cash flows and positive cash impact on their income statement.

The simplicity of this analysis is a true advantage.

However, this model does have its drawbacks.

Businesses do not operate in a world where they can accurately predict cash flows, profitability, investment costs, expenses and so on.

There are many variables that can affect the cash flows of a business making the evaluation of the profitability of a project that much more difficult.

If you do not consider market conditions, regulatory changes, market risk, competition, and all other variables in your assessment, your incremental cash flow model may not provide you with a true and realistic assessment of the cash you may expect from a project.

Accountants and finance professionals may run into difficulties in calculating an estimated incremental cash flow due to:

  • Sunk costs
  • Opportunity costs
  • Cannibalization 
  • Allocated costs

The sunk cost refers to past costs that have already been incurred.

Opportunity costs refers to the cost associated with a missed business opportunity when favoring one project opportunity over another.

Cannibalization is when a new project ends up reducing the cash flows associated with another project, business line, or product.

Finally, allocated costs are business costs associated with a department or project.

Incremental Cash Flows Takeaways 

So, what are incremental cash flows?

How to calculate incremental cash flows for capital budgeting purposes?

Let’s look at a summary of our findings.

Incremental Cash Flow Meaning

  • The “incremental” cash flows are cash flows that a company would expect to receive or pay as a result of the taking of a new project
  • If the company generates a positive incremental cash, then the project is worth considering
  • If the company generates a negative incremental cash, then the project may not be a profitable one
  • Calculating the cash flow incrementally for projects allows a company to quickly evaluate the feasibility of a new project, launching of a new product, or line of business
  • The limitation of this model is that business projects involve many variables and many of which a company cannot control or accurately predict 
Business risk 
Cannibalization 
Capital budgeting 
Capital outlay 
Cost allocation 
Free cash flow 
Incremental earnings 
Incremental income 
Legal policy 
Market risk
Net income 
Operating income 
Opportunity cost 
Regulatory policy 
Sunk cost 
Terminal cost
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Accounting ledgers
Ad hoc payment
Average annual growth rate (AAGR)
Balance sheet
Cash flow per share
Cash flow statement
Crowdfunding 
Discounted cash flow 
EBITDA
Inflation 
Internal Rate of Return
Net present value
Operating cash flow 
Payback period 
Profit and loss statement
Profitability index
Recurring payment 
Statement of operations 
Time value of money 
Weighted average cost of capital (WACC)
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Editorial Staff
Hello Nation! I'm a lawyer by trade and an entrepreneur by spirit. I specialize in law, business, marketing, and technology (and love it!). I'm an expert SEO and content marketer where I deeply enjoy writing content in highly competitive fields. On this blog, I share my experiences, knowledge, and provide you with golden nuggets of useful information. Enjoy!

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