Last Updated on November 10, 2023
Cash flow is the lifeblood of business. It not only showcases the financial health of an organization, but it is also one of the primary variables that will help you decide how to prioritize your company’s next moves.
There are a few different subsidiaries of the general cash flow term, such as net cash flow and incremental cash flow, and the latter we will explore in this article.
For business leaders and decision-makers, understanding the value of incremental cash flow is vital for making the most of the now while looking towards the future. Continue reading to find out what incremental cash flow is, how to calculate it, and why it is an important metric to understand for a business’s financial health.
What Is Incremental Cash Flow?
Incremental cash flow represents the net cash impact that a new project, investment, or campaign has had, or might have, on your company’s finances.
Forecasting future cash flow helps business owners make financial and operational business decisions, such as taking on a new project, by highlighting the additional potential cash flow that new projects could generate on top of what is already expected.
Calculating incremental cash flow from a past project also helps business owners, as it allows them to better understand how a project stacked up against projections and how it compares to other opportunities to generate incremental cash flow in the future.
Incremental Cash Flow vs. Total Cash Flow
Before we get into how to calculate incremental cash flow, let’s review its clear distinction from total cash flow.
Total cash flow refers to the overall cash movement within a business, including all inflows and outflows (which are cash moving into and out of the business, respectively). It provides a comprehensive view of a company’s financial position.
Incremental cash flow focuses solely on the changes in cash flow resulting from a specific investment or project. It isolates the impact of a particular action or investment, helping decision-makers assess whether the potential benefits outweigh the costs.
How to Calculate Incremental Cash Flow
To calculate incremental cash flow, you will forecast three figures regarding your new project: revenue, expenses, and initial cost.
- Revenue = direct revenue from a new product, project, or investment
- Expenses = operational costs for the project
- Initial cost = pre-project costs (if applicable)
Written out, the formula for incremental cash flow looks like this:
Incremental Cash Flow = Revenues – Expenses – Initial Cost
Here are a few basic steps to help walk you through your calculation:
1. Identify the necessary initial costs: Determine all the costs necessary to start the project. For example, if you operate a t-shirt company and want to launch a new design, you will need to determine the initial costs associated with launching that design, such as the purchase of new t-shirts, the printing for an initial production run, etc.
2. Estimate Revenue and Expenses Over a Specified Period: Project revenue and expenses (operational costs) over a specified time period. If your project will have long-term, lasting effects, you can estimate revenue and operational costs over a 5-year period.
3. Consider the Time Value of Money (TVM): Account for the fact that a dollar today is worth more than a dollar received in the future. This tool can help you determine that future figure.
4. Calculate the Incremental Cash Flow: Now you’re ready to follow the formula noted above to project your net incremental cash flow. Once you do so, you will be able to determine whether or not the project will make money for your company.
Example of Incremental Cash Flow
Let’s break this down with an example for practice.
Suppose a company is considering launching Product Line A, which requires an initial investment (initial cost) of $100,000. Operational costs over a 5-year period are expected to be $150,000 with the time value of money taken into account.
The expected revenue from this new product line is estimated to be $350,000 over the next 5 years with the time value of money also taken into account.
Using the formula leaves us with the following:
$350,000 in revenue – $150,000 in expenses – $100,000 initial cost = $100,000
Therefore, the resulting incremental cash flow from this project is $100,000.
Because this is a positive figure, it signals that this new product line will lead to a profit over the course of five years, making it financially viable. The business owner could feel comfortable moving forward.
Contrarily, if it was a negative number, the owner might not want to move forward with launching the new product as it could lead to negative cash flow.
Let’s take our example one step further. Perhaps this same business owner is weighing Product Line A against another investment, Product Line B. Product Line B requires initial costs totaling $50,000. Operational costs are projected to be $100,000 in total over a 5-year period, and revenue is projected to be $300,000.
The incremental cash flow formula for Product Line B is as follows:
$300,000 in revenue – $100,000 in expenses – $50,000 initial costs = $150,000
Therefore, the resulting incremental cash flow for Product Line B is $150,000.
This tells the business owner that they would profit more from launching Product Line B than Product Line A.
And just like that, incremental cash flow has proved highly beneficial for making an important financial decision.
Incremental Cash Flow Calculator
Of course, it’s easier to consider incremental cash flow with a calculator. The below incremental cash flow calculator can assist you in forecasting cash flow for your next project or determining cash flow from a past project.
Why Finding Incremental Cash Flow Is Important
Finding incremental cash flow for each undertaking is crucial for helping businesses improve overall cash flow.
Some other reasons include:
It’s the Key to Determining Whether a Project is Worthwhile
The core function of incremental cash flow in business is determining whether organizations can greenlight a new project. Before starting any project, companies must measure the potential impact on finances.
Calculating incremental cash flow is a form of cash flow analysis that provides critical data needed to make informed choices, and without it, businesses risk making poor decisions that could impact financial stability.
It Offers a Guide for Capital Budgeting
Capital budgeting is the process of evaluating the profitability and feasibility of substantial investments, such as equipment or real estate purchases.
The volume of incremental cash flow serves as a compass for guiding these assessments. This analysis ensures business owners have a holistic understanding of how their money is working for them and will continue to work for them post-capital investment.
It Aids in Future Decision-Making Processes
A strong understanding of this type of cash flow provides leaders with a valuable tool for financial planning. Specifically, comparing projections to reality helps with making more informed decisions in the future.
What to Remember When Calculating Incremental Cash Flow
While calculating incremental cash flow is fairly straightforward once you understand it, keep in mind the following:
- Be precise in identifying relevant cash inflows and outflows.
- Remember the time value of money. $10 today will be worth less than $10 in 2030.
- Consider potential risks and uncertainties that may impact cash flow estimates. For example, an unexpected economic downturn could impact your gross profit from a new investment.
Incremental Cash Flow FAQs
What is the difference between incremental cash flow and free cash flow?
Incremental cash flow focuses on the changes in cash flow resulting from a specific decision or project, while free cash flow represents the cash available to a business after covering all operating expenses, taxes, and investments.
What is the difference between incremental cash flow and operating cash flow?
Operating cash flow refers to the cash generated from a company’s core operations, excluding financing and investment activities. Incremental cash flow is the total cash flow generated from a specific decision or project.
What are the different types of cash flow?
Common types of cash flow include operating cash flow, investing cash flow, financing cash flow, and, obviously, incremental cash flow.
How can I improve my cash flow?
The process of improving your cash flow involves optimizing your revenue streams, minimizing expenses, and managing working capital efficiently. You can see specific tactics to improve your cash flow by reading this article.
As a full-time writer and programmer, Christian spends most of his time typing away for clients around the world on different projects. Christian has several years of experience writing content that addresses financing solutions and accounting methodologies geared toward small and medium-sized businesses. In his free time, he enjoys traveling and learning new skills.