How often do you think about how incremental cash flow impacts your business? For many organizations, few people consider it at all. It’s common for companies to look at all revenue the same. Still, the best way to grow your business progressively and get ahead of the competition is by examining what incremental cash flow means to your goals.
Working out the cash flow generated by new projects gives you a better sense of where you should invest your capital. Whether a group effort or one you designate to a qualified individual, incremental cash flow analysis should be at the center of your company’s growth plan.
Explaining Incremental Cash Flow
Incremental cash flow refers to the money generated by a new project or initiative. Positive incremental cash flow means your business’ cash flow stands to increase when you accept the project, giving you data-driven reasons to go for it. If you determine an undertaking would yield a negative cash flow, it’s best to forgo the opportunity.
This tool proves excellent at discovering which new opportunities will be lucrative, providing a new focus for your company’s long-term planning. Still, you should not rely on just incremental cash flow when analyzing new opportunities. Sometimes business politics and relationships will influence the direction you need to go as a company. Likewise, you could enter a deal with a company in an industry you’re trying to transition your company into, taking slight losses for the sake of future endeavors. While that’s fair, you should keep incremental cash flow in mind to assess how much of a loss you might take for a project you might want to avoid in the future.
Why it is Important to Understand Incremental Cash Flow?
Incremental cash flow determines if your company is ready and able to invest. Anyone investment can significantly affect your company’s trajectory, profitability, and future business operations. You can easily use incremental cash flow to determine the viability of investing in new equipment, replacing a manufacturing plant, or starting a new product line.
Many managers and business owners utilize different techniques to calculate capital budgeting costs, including:
- Payback period: This is when your company gathers funds for the project. For example, if you have ten years to pay back a $1,000 loan, they can pay $100 back per year plus any interest.
- Net present value: This measures the difference between inflows and outflows of money. This offers more detail and specificity than calculating profitability, accounting for discounted rates, and unforeseen expenditures.
- Accounting rate of return: This measures the percentage return from an investment compared to cost. Subtract depreciation and annual expenses to get a yearly net profit.
- Internal rate of return: This gives you a great sense of how you should grow and where to expand in the future.
- Profitability index: This calculates the present value of cash flows paired with the money needed to invest in a venture. Typically, businesses utilize this to show investors why they should invest – while providing a quantified value of that investment.
Calculating Incremental Cash Flow
Suppose your company has two opportunities in front of it. However, you only have the resources to dedicate to one project. This would be a great time to perform an incremental cash flow analysis. Let’s refer to these opportunities as “Option 1” and “Option 2.”
You project Option 1 to yield $300,000 in revenue with an initial cash outlay of $20,000 and $135,000 in expenses. Alternatively, Option 2 will yield $600,000 with a $85,000 initial outlay and $390,000 in expenses. Luckily, solving for incremental cash flow is not complex. You can calculate the incremental cash flow as follows:
Option 1 ICF = $300,000 – $20,000 – $135,000 = $145,000
Option 2 ICF = $600,000 – $85,000 – $390,000 = $125,000
While Option 2 appears enticing with double Option 1’s raw revenue number, it’s clear that your company would benefit more from Option 1, as the costs you’re inputting detract from the overall revenue gained. This example might seem straightforward, but that’s how incremental cash flow works, meaning it’s just as easy to utilize this concept in situations relevant to your business.
Limits of the Formula
While straightforward and generally effective, the incremental cash flow formula has a few weaknesses. In many cases, the dollar values will not be so easy to predict, let alone as definite numbers. Additionally, market and regulatory changes can significantly affect your expenses after taking on a project, especially if the timeline spans more than a few years. Be careful to avoid adding sunk costs into your analysis, as these do not apply to incremental cash flow – an analysis of present and future expenses. Focus on things that happened after your company decided to invest.
Likewise, distinguish between cash flows related to the project and cash flows from other business operations. While these factors together will play a role in business expansion, you want to calculate each value independently so you can compare opportunities with one another. Failing to do so will give you flawed data and a false sense of how to proceed.
The Differences Between Total Cash Flow and Incremental Cash Flow
Contrary to incremental cash flow, total cash flow measures the cash that comes to your business after completing a project. Many companies constantly calculate cumulative cash flow over time, whereas incremental cash flow measures the benefits of changing a project.
Final Thoughts – How can you Make Incremental Cash Flow Work for You?
If you want substantial business growth, year after year, you’re going to want to start employing the incremental cash flow formula every time you are presented with or are considering a new opportunity. Set incremental cash flow goals as needed, automatically rejecting projects that don’t meet your criteria. Making the decision ahead of time to jump on or abandon a project based on incremental cash flow will make the decision easier when the time comes, keeping the process objective and taking the emotions out of committing to an opportunity.
How Foresight CFO Is Different from Other Outsourced CFO Services?
Our experienced Growth CFO team at Foresight CFO has worked collaboratively with hundreds of CEOs worldwide to bring meaningful financial insight that clarifies their strategic direction. Schedule a 25-minute discovery call with me, and we will discuss you & your business, what you want, and what is getting in the way.
