Understanding incremental cash flow (ICF) is important for any organization, especially those considering to invest in new projects. Without calculating the cash flow and profitability of a project, a company can lose money.
Here, ICF is a tool to measure the cash flow projection of any project and provide an idea of whether a company should invest in it or not.
In this post, I cover every aspect of incremental cash flow, including essential concepts, real-life examples, and its crucial importance. So let’s explore.
What is Incremental Cash Flow
Incremental cash flow is an indicator that guides a company on whether to invest in a new project. In other words, this indicator determines the project’s profitability.
Ever wondered how companies decide which projects to invest in? It’s based on analyzing and calculating ICF. This metric calculates the outflow and inflow of a specific project, considering values like revenue and expenses.
Incremental cash flow is the amount of money that will be added to the company’s cash flow if the company takes on the specific project. It’s not always true that all projects will become positive cash inflow for the company; many projects may not work as predicted, leading to a loss for the company, turning into an outflow.
That’s why we need incremental cash flow to show the profitability of the company. If the ICF is positive, it means the company will get a good return on investment. But if it’s negative, the company will lose money, indicating an unprofitable project.
How to Calculate Incremental Cash Flow
Calculating incremental cash flow is not hard; it requires a little understanding of some parameters used in the formula.
To find out the ICF value, subtract the initial cost from the revenue, then subtract the expenses related to the project. First, look at this incremental cash flow formula:
ICF = (Revenue – Initial outlay) – Expenses
If this value is positive, it is advisable to invest in the project for a profitable deal, bringing money to your cash flow statement. But if this value is negative, you should avoid the project, as it indicates a loss of money.
Now, let’s understand these in brief.
Initial Cash Outlay: It’s the cash outgoing from the company, in other words, the cash outflow. When a company invests the initial cost in any project to start it, it’s called the initial cash cost.
For example, if a company like Reliance launches a new soft drink named Campa, preparing all the documents, manufacturing plant setup, and the first soft drink production will be considered the initial cost.
Revenue: The money a firm earns from its core operating activities is called revenue. It is calculated specifically for a product to determine how much a firm will generate inflow from the product if they invest in this project.
In the above example, Reliance will earn revenue from Campa (soft drink), which will undoubtedly be more than its raw material and other expenses.
Expenses: Expenses include all things such as wages, salaries, bills, etc. They are subtracted from revenue to find out the profit. In simple words, it represents the outflow of cash from operating activities.
Taking Reliance’s soft drink example again, they would need raw materials for making the soft drink, as well as employees, electricity, and godowns. All of these would be calculated as expenses.
Example of Incremental Cash Flow
Understanding by using examples gives you a clearer idea of how ICF works. Here are two examples for you – the first one is normal, and the second one involves two products.
Example 1:
Assume a company called Samsung wants to launch a new mobile phone as a new project. In this case, they will need to initially invest $1m, and expenses will cost $500k.
According to the forecast report, this product will generate revenue of $2.5m
Let’s calculate using the formula:
ICF = (Revenue – Initial payout) – Expenses
ICF = (2.5m – 1.0m) – 0.5m = 1m
If the company spends that money, it will earn a good amount of money in return on investment.
Example 2:
Assume we have a software agency with a good amount of money to invest in any one project.
After doing research, we know that there are two new products to launch: Income management software and cash flow management software.
For the income software, it requires an initial cost of $45,000, and the expense cost, including marketing and advertising, is $35,000. Calculating its forecast, it will generate revenue of $120,000.
On the other side, the cash flow software requires an initial cost of $50,000 and $45,000 in expenses. It will generate revenue worth $130,000.
Let’s calculate both of them.
Income Software:
ICF = (120,000 – 45,000) – 35,000 = 40,000
Cash Flow Software:
ICF = (130,000 – 50,000) – 45,000 = 35,000
Here, the cash flow software generates more revenue compared to the income software. Still, it is a good idea to invest in the income software because of high incremental cash flow.
That’s how you can calculate more than one project to identify which one is more profitable for your company.
Remember, ICF is not enough to forecast the future business position. You will also need some other methods as well.
Incremental cash flow Limitations
Estimating a business position using Incremental Cash Flow (ICF) is not as simple as it sounds. Beyond revenue and expenses, several other factors significantly affect incremental cash flow, such as government policies, market conditions, and legal services.
Some parameters are not included when calculating ICF, such as:
Cannibalization: This occurs when a newly launched project affects the same company’s second product. For example, if a company named ABC launches a new type of biscuit (X), and the company already has another biscuit (Y), people may shift from Y biscuit to X, affecting the same company that launched both biscuits. ICF does not include this effect.
Sunk Cost: This cost reflects an amount that will never be covered. Regardless of the decision made on the project, this value will be permanently gone. Sunk cost is also not included in ICF.
Opportunity Cost: This occurs when you miss out on an opportunity and don’t take the profit from that. For example, if you have two options to invest $1000 in marketing or a survey, choosing marketing means you will lose the result you could have gotten from the survey as an opportunity.
Special Section
Incremental Cash Flow Importance
Incremental cash flow is a powerful tool with significant importance in the financial world.
Its first use is to select a project. By forecasting the project using incremental cash flow, you can determine the profitability of the company and decide whether to invest in it or not.
Despite external factors affecting the project, it remains useful. Many cash flow software options offer financial forecasting, Finmark is one of the renowned ones.
Incremental cash flow provides the freedom to compare many projects together to identify which one gives maximum investment returns and fits within the business time period.
Additionally, tracking ICF during the project provides insights for necessary changes to increase profitability. If it indicates negative cash flow, you can implement expense management strategies to decrease the outflow of the project.
Calculating with Other Methods
While incremental cash flow is an excellent indicator for choosing a project and making financial decisions, it alone is not enough. You will need additional methods to combine with ICF in financial decision-making.
Here are some methods you can apply during calculating ICF:
1. Payback Period: This calculates how much time will be taken to recover all investments, known as the payback period.
2. Net Present Value: The difference between cash inflow and outflow for a specific period is called net present value. Using this, you can obtain more detailed information about your profit.
3. Accounting Rate of Return: As the name suggests, accounting rate of return is how much a company gets in return from the invested compared to its cost. To calculate this, subtract all expenses, including depreciation, from annual revenue and get the annual profit of the project.
Incremental Cash Flow vs Total Cash Flow
Both are crucial from a business viewpoint, but their use differs based on the context.
Total Cash Flow: This metric provides a comprehensive view of the entire firm—showing how much money comes in and goes out. It encompasses all expenses and earnings from all activities, offering insights into the business’s health and actual position in the market. Total cash flow is essential for financial planning, providing a holistic perspective.
Incremental Cash Flow: This indicates cash flow specific to a particular project. While it doesn’t offer a complete overview of the entire business, it serves a vital role in deciding whether to invest in a project or not.
Conclusion
In summary, incremental cash flow is crucial for the financial success of a project. However, relying solely on this tool is not advisable. It should be used in conjunction with other methods to make well-informed financial decisions.
Additionally, having basic information about the cash flow statement is necessary before delving into Incremental Cash Flow.
I recommend to you reading my definitive guide on cash flow with visual aids. It will undoubtedly boost your financial knowledge.