Before we start discussing incremental cash flow, let’s spend a little bit of time discussing what cash flow is. If you are a business owner and you are reading this, you definitely know what cash flow is. If you want to be a business owner, you definitely want to know what cash flow is. While finance may seem complicated and convoluted with its bazillion terms and tools, in essence most finance revolves around building net worth. In the end, it’s about letting compound interest work for you by setting your money aside without touching it for 20-30 years. Cash flow, as business owners would know, means how often is the cash coming in, how easily accessible is the money once it’s in there, how frequently is it coming in, and how much of a flow is it. If there is not much cash flow, but there is a lot of net worth, you can end up in bankruptcy. Why? Because you might have bills to pay and obligations that are out there. Poor cash flow can squeeze you out of your wealth, but if you focus on cash flow, not just on how much you make, but also how much you keep, you can slowly but surely, create wealth. Your bottom-line revenue is what you must focus on. There is no doubt that top line revenue is important. At times, it’s about bragging rights, but cash flow and bottom-line is about what you can do with your money once its gone through all your expenses (fixed + variable costs) and taxes. What’s left over for you to enjoy, build liquidity and safety and ultimately create wealth.
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.