Companies often have to make funding decisions regarding particular projects. An incremental cash flow analysis can help this process by showing the additional cash flow generated by a particular project. Incremental cash flow or incremental cash flow from operations is the incremental operating income plus the noncash incremental depreciation expenses added back in. Operating income is sales minus operating expenses.
Compute your baseline or regular operating cash flow without new projects. It is equal to operating income plus depreciation expenses. Depreciation is the annual allocation of fixed asset acquisition costs. For example, if your operating income is $1 million and depreciation expenses are $100,000, the operating cash flow is $1.1 million. Note that this is a simplified example that assumes cash sales only and no changes in working capital (current assets minus current liabilities).
Identify the incremental sales from a new project, which is the estimated sales with the new project minus the regular sales. The additional sales might not materialize immediately. For example, if you are expanding into a new geographic territory, you are not going to see an immediate sales pickup because it takes time to establish new distribution channels and develop a steady customer base.
Compute the incremental operating expenses, which is the estimated expenses with the new project minus the regular expenses. In the geographic expansion example, you will incur additional expenses for new staff, equipment, facilities and marketing. These expenses might be high for the first year or two, but then stabilize as the staff ramp-up and other initial costs are out of the way.
Add back the changes in noncash operating expenses, such as depreciation expenses, into your calculation. When you replace old equipment, buy new equipment or build new facilities, you will incur additional depreciation expenses. Although these expenses are recorded on the books as operating expenses, they must be added back to cash flow because they are noncash expenses.
Calculate the incremental cash flow, which is equal to the incremental sales minus incremental operating expenses plus changes in noncash operating expenses. Continuing with the example, if the incremental sales over a five-year period are $2 million, the incremental operating expenses are $1 million and depreciation expenses are $500,000, then the total incremental cash flow is $1.5 million ($2 million - $1 million + $500,000). If your average corporate tax rate is 20 percent, then the after-tax incremental cash flow is $1.2 million [$1.5 million x (1 - 0.20) = $1.5 million x 0.80 = $1.2 million].
Consider the opportunity costs of undertaking a new project. Opportunity costs mean that time and resources invested in one project cannot be used on other projects because businesses generally operate with finite resources. In the geographic expansion example, if you decide to expand into the Chinese market, diverting some of your managerial resources to develop this market might cause sales to temporarily suffer in your existing markets. To close out the example, if the expansion project results in cash flow reductions from other existing operations of $200,000, then the net incremental cash flow is $1 million ($1.2 million - $200,000).