What is Unconventional Cash Flow?
An unconventional cash flow profile is a series of cash flows that, over time, don’t go in only one direction. It is characterized by not just one, but several changes in the direction of the cash flow. Directional changes are usually represented by the positive (+) and negative (–) signs. The positive sign (+) denotes a cash inflow of cash, while the negative (–) sign denotes an outflow of cash.
Unconventional cash flows may look like the following example:
- 2015: + 1,000,000
- 2016: – 300,000
- 2017: + 500,000
- 2018: – 200,000
The information above shows an unconventional cash flow profile for the company because of the series of cash flow direction changes.
Unconventional cash flows are more difficult to deal with because they include more than one Internal Rate of Return (IRR).
Unconventional Cash Flow and the Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a financial metric used for measuring cash flow. IRR is specifically utilized to evaluate acquisitions and other business investments. The metric can provide a general overview of a company’s financial status and help to predict future cash flows.
A company with a conventional cash flow profile will normally show just a single IRR, but a company with an unconventional cash flow will demonstrate multiple IRRs.
Note: Always be sure to use the more accurate XIRR instead of IRR in Excel.
Conventional cash flow vs. Unconventional cash flow
Here are the differences between conventional cash flow and unconventional cash flow:
Conventional cash flow reflects only one direction in the cash flow of a company or organization. Usually, cash outflows occur only once – at the beginning of a project – after which, all cash flows are inflows. The initial outflow is, of course, the capital required for funding the project. The subsequent cash inflows represent revenue or profits received. There may be an initial cash inflow if the project is funded with capital borrowed from a bank or other financial institution.
For example, assume Company Z wants to open a new branch office in a major city. To pay for the new office, the company borrows a certain amount of money from the bank. The money that the bank puts into the company’s account is a cash inflow.
An outflow of all or part of the funding occurs when Company Z begins work on building the new branch office. Deposits, from revenues, that are made to repay the bank financing are recorded as cash inflow. When financing payments of either principal or interest are made to the back, such payments appear as cash outflows.
Unconventional cash flow, on the other hand, reflects a series of cash flows in different directions over a period of time. Such cash flow profiles are very common among businesses that require periodic maintenance of equipment.
Say, for example, an investor owns a 20-room hostel. The owner may see an unconventional cash flow because once every five years, a maintenance check and renovation need to be done to ensure the quality of the amenities that the hostel’s guests use.
Another example can be seen in people’s daily lives, such as the simple process of withdrawing money from an account to pay monthly expenses. A person who keeps a careful list of monthly expenses knows precisely how much he or she needs to withdraw from the bank.
However, someone less careful with their finances may tend to initially withdraw more money than they need, then redeposit some of the withdrawn funds. In any event, they will have more complicated unconventional cash flows from month to month.
Challenges from an Unconventional Cash Flow
Unconventional cash flow, as noted above, is characterized by a series of cash flows in different directions. This creates multiple different IRRs, which makes it more difficult for an analyst to value such a company. Once determined, IRRs are compared to the company’s hurdle rate or to the lowest possible return rate of a project.
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