Incremental Cash Flow

When you’re approaching a new project, campaign, or investment, you want to know that it’s a worthwhile use of the company’s resources.

Using incremental cash flow, you can determine the additional cash flow that your business will generate or lose from these ventures and gain an objective way to compare different opportunities against one another.

So if you’ve been wondering how to measure the ROI of a new campaign or product line expansion, using incremental cash flow will provide you with some important context and information so you can make a decision that makes sense financially for the business.

Below, we will define what incremental cash flow is, walk you through the formula to calculate it, and discuss the advantages and limitations of this metric.

What is Incremental Cash Flow?

Incremental cash flow is the additional operating cash flow that you will generate or lose from taking on a new venture, project, campaign, or investment. 

Forecasting incremental cash flow provides business leaders with an objective way to assess the economic viability before accepting a new project. In this way, you can compare two or more opportunities side-by-side to select which one would be more profitable.

Put differently, measuring incremental cash flow is a way to assess the potential return on investment (ROI) of a given project.

If the incremental cash flow is positive, it signifies that taking on the new project will increase your cash flow. In this case, it would make sense for you to invest in the project.

On the other hand, if the incremental cash flow is negative, this signals that taking on the project would actually produce a net loss, and likely isn’t a good investment of your resources.

Incremental Cash Flow vs. Cash Flow

Though the two terms are similar, there are some distinct differences between incremental cash flow and cash flow that you should be aware of.

For instance, both metrics can help you determine where your business is generating cash flow, and where the majority of the cash is being spent.

However, incremental cash flow focuses on the net cash flows generated or used by one specific project or investment, while total cash flow focuses on the actual cash flow that came into or out of the business during a given time period.

In this way, total cash flow is a better indicator of past performance and the financial health of your overall operations by showing the cash that actually flowed through the business.

But, forecasting incremental cash flow will help you make informed decisions about where to best deploy the company’s resources and evaluate potential revenue opportunities. It can offer insights about the specific ROI of a given project, which total cash flow doesn’t provide.

How to Calculate Incremental Cash Flow

On a basic level, incremental cash flow is the net value of all cash inflows and outflows that a specific project will generate.

But, there are a few key pieces of information you will need to gather before you can determine this final value.

Some of the main elements you’ll need to identify to calculate incremental cash flows include:

• Initial cash outlay: the initial investment the business will make in the project
• Revenue projections: the cash inflows you expect the project to generate
• Expected expenses: the projected costs of the new project

As you can see, each of the components in the incremental cash flow calculation is based on projections and expectations to some degree.

Because of this, there is some additional preparation work that will go into the incremental cash flow calculation, as the components of the formula aren’t just items you can pull from your financial statements.

Once you have each of these assumptions made, you can use the following formula to calculate the incremental cash flow for a project:

Incremental CF = (Cash Inflow from Project – Cash Outflow from Project) – Initial Investment

You can make these calculations by hand, or use Finmark from BILL to calculate incremental cash flow using your business’s financial data.

Incremental Cash Flow Example

Let’s consider a business that wants to expand their product lines, and they have two different options that they could invest in.

By forecasting the incremental cash flows for each option, they can determine which one would produce the most economic benefit for the company.

In other words, we want to see which product line expansion would produce the highest incremental cash flow–Line X or Line Y.

In this case, we assume that Line X will produce revenues of $60,000 and expenses of $12,000 over the next year.

Line Y is projected to produce $72,000 in revenues and incur expenses of $23,000 during the same time period.

Line X would require an initial capital investment of $8,500 for R&D, while Line Y would require an initial cash outlay of $14,000 for R&D and the purchase of new machinery to produce the products.

Here is the incremental cash flow that Line X would produce:

Line X Incremental CF = ($60,000 – $12,000) – $8,500

  = $48,000 – $8,500

  = $39,500 

And here is the incremental cash flow for Line Y:

Line Y Incremental CF = ($72,000 – $23,000) – $14,000

  = $49,000 – $14,000

  = $35,000

From this example, we can see that the incremental cash flow of investing in Product Line X would produce an extra $39,500 for the business while expanding to Produce Line Y would provide the company with an extra $35,000 for the year.

Even though Line Y is expected to produce more income, the expenses of this product line expansion are much higher than for Line X, making it a less profitable opportunity for the company.

This calculation also shows that both product line expansions would be profitable for the business, as they both are expected to produce a positive incremental cash flow for the business.

But, there is clearly one product line that would offer more of an ROI to the business than the other. So, in most cases, the business would choose product Line X for expansion.

Why Should Businesses Calculate Incremental Cash Flow?

As you can see from the above example, forecasting incremental cash flow can help you compare different projects or ventures to determine which is the most viable or profitable for the company.

This can help you see which project or opportunity would provide the business with the most cash. Additionally, it can be helpful to reject or avoid investing in opportunities that would end up with a negative incremental cash flow–or costing the company more money than it generated in revenues.

Plus, after the investment or project has been chosen, you can continue tracking the incremental cash flow it’s producing to evaluate its performance and make changes or adjustments as necessary to boost profitability.

For instance, if you determine that a project is producing negative incremental cash flows, you can see where you can cut costs to avoid losing money on the investment as a whole.

Limitations of Incremental Cash Flow

Forecasting incremental cash flow can provide you with an objective way to assess the potential profitability of a new project or venture.

However, this likely isn’t the only metric that you’ll use to make the final decision on whether or not to pursue the opportunity.

Plus, it’s important to understand the possible shortcomings and limitations of this metric so you can make more informed decisions that will benefit the business.

The formula for calculating incremental cash flow may appear simple, subtracting the total costs from the expenses.

But, as we briefly mentioned above, this relies on forecasted expectations for the revenues and expenses that the project or investment will produce.

As such, the accuracy of these projections will play a big role in how accurate the incremental cash flow forecast is.

It can be difficult to nail down each of these variables with a high degree of accuracy, especially due to factors that are external to the business like:

• The market demand for the product
• Changing regulatory landscape
• New competing market entrants

Aside from the limitations of the formula itself, you also shouldn’t overlook the ripple effects that can occur throughout your business if you invest in a new project, even if your calculations show it will generate a positive incremental cash flow.

For instance, you need to take into account the possibility of cannibalization if you invest in a new product line.

This means that even though the product line itself will generate a positive cash flow, you may detract demand from other product lines, and start losing revenue elsewhere in the business.

All in all, it can be useful to use incremental cash flow to determine the viability of investing in new projects, but you should be sure to expand your lens and take a comprehensive look at the investment or project before making the final decision.

Start Forecasting Incremental Cash Flow Today

Incremental cash flow is a useful metric that can help you evaluate and gauge the profitability of various business ventures.

To gain better insights into the different revenue opportunities for your business, use Finmark to calculate and compare the incremental cash flows for various ventures to see which one makes the most sense economically.

Get started with your 30-day free trial today.