Understanding cash flow is an essential part of running any business effectively. It’s easy to get so swept up by revenue that you actually miss out on your profitability. And when you do calculate cash flow, there are a few different formulas and factors that you need to consider. Incremental cash flow is one approach.
This tactic is used when a business is planning for a new project or investment, and they need to understand an accurate financial projection of this. In this quick guide, we’ll cover what incremental cash flow is, how it works, and how you can calculate it for your business.
What are Relevant and Incremental Cash Flows?
This is the cash flow that a business can expect in the future. These cash flow predictions are made based on a certain new project, or product, that the business is considering. Incremental cash flow is calculated when a business is planning to take on a new project. The cash flow considers the additional startup costs and operating expenses of the new project. This is done to understand what the business’s profits and revenues will look like should they go ahead with this project. This is generally determined if the incremental cash flow is positive.
How Do You Calculate Incremental Cash Flow?
To calculate incremental cash flow, you will need to use the following formula: Revenue – expenses = initial costs
To do this, you will need to have accurate cash flow forecasts for your potential revenue and operating expenses for the new project.
To break it down a bit more, here are the specific processes you need to follow to figure out your incremental cash flow:
- Figure out what your business’s revenue is (how much money is coming in)
- Figure out what all of your business expenses add up to (how much money is going out)
- Subtract your revenue from your expenses
- Note the initial cost of the project that you are calculating incremental revenue around
- Take the total calculated in step three, and subtract this total from the initial project cost
Now you will have calculated your incremental cash flow. You can repeat this process for different projects and compare your totals.
Example Of Incremental Cash Flows
Incremental cash flow should be calculated whenever your business plans to dive into a new venture or project. For example, let’s say you want to update your existing product and introduce a new version of it. In planning this, you have two possible new product options you could go with, product A and product B.
Here are the revenue projections for each product over the course of a year:
- Product A: R500 000
- Product B: R800 000
Here are the expenses of each product over the course of a year:
- Product A: R150 000
- Product B: R500 000
Here are the initial startup costs for each product:
- Product A: R50 000
- Product B: R35 000
let’s calculate the incremental cash flows for each product based on this information:
- Product A: 500 000 – 150 000 – 50 000 = R300 000
- Product B: 800 000 – 500 000 – 35 000 = R265 000
So, product B may generate more revenue, but it has a lower incremental cash flow due to its expenses and startup costs. This could mean product A might be a smarter choice for your business.
Why is Incremental Cash Flow Important?
Incremental cash flow helps you understand the cash flow predictions and profit potential of a new project. This is necessary for figuring out how viable the new project is, and what your business’s overall cash flow would look like should you proceed with the new project.
As in the example above, understanding incremental cash flow can also help you compare different project or product options, to figure out which would be best financially for your business.
Incremental cash flow predicts the possible increase or decrease in a business’ revenue related to a specific new project. This could be investing in new equipment or a new facility, introducing a new product line, updating a new product, offering a new service, or more.
Whatever the case, any kind of business should understand how incremental cash flow works to help them make more informed decisions. Carefully calculating this can help you avoid unwanted surprises in your cash flow further down the line. It’s a valuable tool for understanding where best you can invest your time and money, and what kind of impact certain investments would have on your business.
SEE ALSO: YOUR DEFINITIVE GUIDE TO FINALLY UNDERSTAND CASH FLOW.
