Incremental Cash Flows In Financial Modeling

Whilst it is common to consider cash flows in a financial model from a financial statement analysis perspective, a good financial analyst should also consider the concept of cash flow from the perspective of assessing a new business opportunity or capital investment project.

The additional operating cash flow that a company or business owner receives from taking on a new project is termed the incremental cash flow. A positive incremental cash flow means that the company’s cash flow will increase if the project is implemented, and a company should probably invest time, resources and capital in the project. A negative incremental cash flow, on the other hand, will provide a financial modeler with an indication that the company probably should not proceed with the project unless there is a strategic or competitive rationale that exceeds the need for financial viability.

In a financial modeling exercise involving the assessment of incremental cash flows, there are several components that should be considered, these include: the initial capital outlay, the cash flows attained from implementing / investing in the project, the terminal value or cost, and the scale and timing of the project.

Here are some examples of incremental cash flows to consider in a financial modeling exercise, in a number of basic categories:

Net initial investment outlay: The net initial investment outlay comprises of cash expenditures, changes in net working capital, net cash flow from the sale of existing / old or non-useful equipment, and investment tax credits.
Net operating cash flow: Net operating cash flow is the revenue net of expenses and tax liabilities for the time period under consideration.
Net salvage value: The net salvage value is the after tax net cash flow for the termination, liquidation or sale of an investment, project or business that is financially unsustainable or which the owner simply no longer wishes to keep. This comprises of sale of assets, cleanup and removal expenses, and release of net working capital.

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