Incremental Cash Flow (With Definitions and Examples)
Cash flow is the increment or decrement in the revenue of a company during a period. Incremental cash flow (ICF) refers to the cash flow of a company when it acquires a new project. Knowledge of ICF can help you understand how companies use this technique to determine where to invest their capital. In this article, we discuss what incremental cash flow is, learn why it's important, review its limitations, compare it to total cash flow, find out how to calculate ICF, and view an example.
What is incremental cash flow?
An incremental cash flow is an increase or decrease in a company's cash flow resulting from the acceptance of a project or the purchase of a new asset. Positive ICF indicates that the investment is more profitable than the costs incurred by the company. A negative ICF shows that a company's cash flow may reduce upon acceptance of a project or an investment and may not be profitable long-term. Companies can use ICF as one of the metrics to determine whether to invest in an asset. The factors that influence ICF include:
Regulatory changes proposed by the government
Changes in the internal policy and priorities of the management
Interest rate hikes
Why is ICF important?
ICFs are important for determining if a business can invest in new projects. Based on its analysis, a company can explain how each decision affects its future cash flow, profitability, and business operations. A company uses ICF for capital budgeting, which is a process by which professionals determine a project's potential risks and long-term return on investment (ROI). A company may use ICF for determining the feasibility of acquisition of new equipment, technology, and buildings, maintenance of existing equipment technology, renovating existing buildings, launching new products, increasing workforce, and exploring new markets.
Using capital budgeting, companies prepare budgets, allocate resources, identify potential risks, assess the long-term potential of a project, and establish an estimated timeline for its completion. During capital budgeting, companies can use ICF projections to calculate:
Payback period: The payback period is a measure of the time it takes for a company to recover an investment.
Net present value: Net present value is the difference between the current value of an investment and the cost resulting from an investment.
Accounting rate of return: Accounting rate of return allows companies to determine the profitability of an asset or investment.
Profitability index: It's a technique used for measuring a project's profitability by dividing the projected inflow by the investment.
Internal rate of return: It's the annual rate of growth that the company can generate from making an investment.
Limitations of ICF
Some limitations in using ICF as a metric are:
ICF doesn't consider sunk costs, which represent the amount incurred by a company before the commencement of a project. ICF focuses on future costs and doesn't include sunk costs in the calculation. Expenditure on research, marketing, equipment, and payroll are all examples of sunk costs. Consider the following example:
Trifecta Marketing spends $75,000 on marketing research to determine if expanding its stores to a particular country can yield profits. The company calculates the expansion might lead to losses. Even though they don't expand in that region, their $75,000 investment represents a sunk cost.
ICF doesn't consider the cost of missed opportunities where a company might have invested in a different project or asset and generated more profits. Here's an example:
George's Co. invests in a project, which manufactures computers that are energy-efficient, lightweight, and provide higher storage capabilities. There's a similar project which manufactures computers that provide a large amount of cloud storage, consume fewer hardware resources to run GPU intense programs, and have an in-built high-performance GPU. By investing in the second project, which launched around the same time, George's Co. might have generated more profit.
This refers to the loss in overall revenue of a company when the new investment or project results in the reduction of cash flow in existing projects. Here's an example:
Shiny Objects Inc. sells luxury products in one part of the city. It opens three more stores that sell mid-range products. This results in cannibalization because people no longer visit the first store as they're able to buy products at a lower cost in three other stores. Although the company gains ICF for the new stores, it loses a major revenue source from its luxury store, which results in a loss overall.
What's the difference between ICF and total cash flow?
ICF is the estimated revenue that an organization receives if it begins a new project or invests in an asset. A business' total cash flow is the amount of cash it receives following the completion of a project. Whenever a company calculates cumulative cash flow, it measures revenue generated over a period, whereas ICF reflects the return on investment for a new project or asset. Companies use ICF to estimate the return on investment on newer projects, riskier assets, and equipment.
How to calculate ICF
Follow these steps if you want to calculate ICF:
1. Identify the company's revenue
Start by calculating the revenue that a company may generate when investing in a project or buying an asset. This is the amount that a company makes before accounting for the costs of manufacturing and labour. For example:
If a company invests in software to extract data from legacy documents, it can generate a revenue of $150,000 per year.
2. Calculate the expenses
Take into consideration the operational expenses, which may include manufacturing costs, labour costs, or the cost of investing in a project. Subtract this value from the revenue. For example:
The operational cost of running the software, including hardware and storage, totals $50,000. Subtracting this from revenue gives $100,000.
3. Determine the initial cost of the project
Consider the initial cost of beginning a project. Common types of expenses include labour, materials, equipment, services, software, hardware, facilities, and contingency costs. Subtract this from the value obtained in the previous step. For example:
The initial cost of implementing the software includes subscriptions to cloud storage and security systems. The cost totals $10,000. Subtracting this from $100,000 gives $90,000.
4. Calculate the ICF
Subtract the expenses and initial costs from the revenue to determine the ICF of the investment. Companies can then use this metric to determine if investing in a project or an asset can result in profitability. For example:
By subtracting the initial cost and expenses, which is $50,000 and $10,000, from revenue, which is $150,000, the ICF is $90,000. The ICF is positive, so the company can generate profits if it were to buy the software.
Examples of calculating ICF
Refer to the following examples to calculate ICF:
Example of calculating ICF to determine where to invest
In this example, a company wants to use ICF to determine in which project it wants to invest:
Global Computers is considering investing in a project to develop computers that are lightweight, energy-efficient, and fast. They have two alternatives, Project A and Project B. For Project A, the revenue forecast is $100,000, and the expenses are $20,000. For Project B, the revenue forecast is $225,000, and the expenses are $160,000. The initial cost for Project A is $20,000 and $15,000 for Project B.
Incremental cash flow = Revenues - Expenses - Initial cost
Expenses for Project A: $20,000
Expenses for Project B: $160,000
Revenue for Project A: $100,000
Revenue for Project B: $225,000
Initial cost for Project A: $20,000
Initial cost for Project B: $15,000
ICF of Project A = $100,000 (Revenue) - $20,000 (Expenses) - $20,000 (Initial cost) = $60,000
ICF of Project B = $225,000 (Revenue) - $160,000 (Expenses) - $15,000 (Initial cost) = $50,000
Even though Project B generates more revenue than Project A, its ICF is $10,000 less compared to Project A's ICF. If the company uses ICF as its only metric, investing in Project A can be beneficial.
Example of calculating ICF to determine whether to expand stores
A company wishes to determine if expanding its stores can generate profits by utilizing ICF:
Cart Max, a grocery store, wishes to expand its operation to a particular city. The revenue forecast upon expansion is $750,000. It can incur operational expenses of $400,000. The initial cost to set up the store is $500,000 to buy a warehouse and storage unit, along with furniture and decor.
Revenue forecasted: $750,000
Initial cost: $500,000
ICF = $750,000 (Revenue) - $400,000 (Expenses) - $500,000 (Initial cost) = -$150,000
Even though the revenue forecasted is high, the ICF is negative. This means that the company can incur a loss of $150,000 if it were to set up a store in a particular region.
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