June 19, 2019
Finance

# Incremental Cash Flow – Definition , How To Calculate

Now that we have created some clarity on cash flow, let’s delve into incremental cash flow. Whenever an organization takes up a new project and receives additional operating cash as a result, it is known as incremental cash flow. Positive incremental cash flow signifies an increase in the company’s cash flow once the new project is accepted. It is also a key point for an organization to consider while investing in a project.

## Understanding incremental cash flow and its uses

While trying to analyse and understand incremental cash flow, the following four components need to be identified: scale and timing of the project, cash flow resulting from the project’s acceptance, initial outlay and the terminal cost.

Over a specific period of time, two or more business choices will create certain amounts of cash inflow and outflow. Incremental cash flow is the net cash flow from those. Needless to say, a positive incremental cash flow is what businesses target . To calculate a project’s IRR (Internal Rate of Return), NPV (Net Present Value) and the payback period, incremental cash flow projections are indispensable. Quite a few items of an organization’s balance sheet can also be projected with the help of incremental cash flow projections.

## How to calculate incremental cash flow?

There is no better or simpler way to explain this process than by using an example. Let’s assume an automobile company is planning to launch a bike within a certain market segment and the product design and development team has given two options, Bike A and Bike B. Through the next fiscal year, Bike A is projected to generate revenues of \$500,000 and expenses of \$100,000. Bike B’s revenues are expected to be \$625,000 and the expenses are expected to amount to \$240,000. The initial cash outlay for Bike A would be \$65,000, while that for Bike B would be \$55,000.

The incremental cash flow of each project can be calculated using the following formula:

#### Incremental cash flow = Revenues – Expenses – Initial Cost

Applying this formula to the aforementioned numbers, we can calculate the incremental cash flow for both the bike projects.

Incremental cash flow for Bike A = \$500,000 – \$100,000 – \$65,000 = \$335,000

Incremental cash flow for Bike B = \$625,000 – \$240,000 – \$55,000 = \$330,000

You can clearly see that even though Bike B is projected to generate \$125,000 more in revenue than Bike A, its incremental cash flow is actually \$5,000 less than Bike A because of its higher overhead expenses. So, if incremental cash flow was the main criteria for project selection, Bike B will get the green signal from the automobile company’s finance department.

In the real world though, incremental cash flows are not so easy to project, and calculating their projections usually end up being an extremely difficult exercise. The sheer amount of real life variables (internal and external) which affect businesses are almost impossible to predict. Legal policies, regulatory policies and market conditions tend to impact incremental cash flows in unexpected and unpredictable ways. Distinguishing between cash flows from a firm’s other business operations and a single project is another major hurdle. The lack of proper distinction can lead to disastrous consequences and the inaccurate data can end up in the selection of the wrong, unprofitable project.