Understanding Incremental Cash Flow vs. Total Cash Flow
Looking through rose-colored glasses portrays the role of a business owner in a much different light. It shows someone who reaps all the profits of their work and yet, comes and goes as they please. But as the person actually in that position, you know firsthand all the responsibilities and long hours the job entails.
One of the most critical parts of your work is knowing how to handle your cash flow and make predictions about the future. As your business grows, you’ll turn some of that cash into investments and use the rest to pay off debt and increase profits.
The Relationship Between Cash Flow and Decisions
You base company decisions on your knowledge of incremental and total cash flow — even if you don’t realize you’re doing it. Learning to approach these decisions in a strategic, formulaic way will help drive you to greater success.
When you know your incremental cash flow and your total cash flow, you have essential information at your fingertips. This guide will teach you the metrics you can use to analyze your cash flow, assess possible challenges, and make changes as necessary.
1. What is Incremental Cash Flow?
Incremental cash flow isn’t a term you regularly hear unless you’re getting deep into your business’s accounting. But it’s a crucial piece of information that you should consider any time you take on an order.
This term is what we call any cash flow that your company gets when it accepts a new client’s order or a project. An “increment” is an increase in something in fixed measures. When it refers to your cash flow, it’s how your revenue will increase with your new work.
Determining Incremental Cash Flow
Imagine a business that accepts a major project, thinking only about the payday at the end. The client agrees to pay $50,000 for the services, which sounds like a hefty amount to the owner.
But the owner doesn’t take into account the labor, equipment, and supplies involved in the project. The work requires dipping into other parts of the business to cover the expenses. Eventually, the project ends up costing more than the $50,000 payday.
You can avoid this problem by estimating the incremental cash flow before you agree to a project.
If the new work will impact the working capital in other parts of your business, how will you budget?
Using money allocated for another expense to cover a project has a special term:
Cannibalization.
Much like it sounds — it’s not a good business idea. You can avoid this by planning ahead and analyzing the future cash flow processes.
Challenges To Estimating the Incremental Cash Flow
If you’re not familiar with the process of determining incremental cash flow, work with your accountant first. Over time and repetitive analysis, the steps will become natural.
When you can use capital budgeting decisions to analyze if a project is worth the cost, it’s hugely beneficial. If there isn’t enough profitability on the table, it’s best to know ahead of time. But some challenges prevent it from being entirely accurate.
Keep these challenges in mind as you work through the decision-making process:
Don’t Include Sunk Costs
These are expenses, or past costs, that you already settled before the current project was even in the cards.
Examples of sunk costs include:
- Rent
- Salaried labor
- Existing equipment
Some accountants automatically include these expenses into the incremental cash flow. It’s in your best interest to purposely exclude them, so you have the most accurate data.
Consider Any Opportunity Costs
Is your business missing out on revenue that it could net from other areas, too?
Opportunity costs could be as simple as turning down multiple other jobs to focus on one large project.
Is the new product’s profitability going to make up for the lack of additional cash flow?
Double-Check Your Balance Sheet
As you work your balance sheet, make sure to allocate costs to the correct category.
For instance, you don’t want to add the phone bill to the net cash flow balance statement. It will impact your decision about the feasibility of the project.
Make Sound Investments
While you’re making your investment decisions, be sure to avoid cannibalization.
Is the cost of capital to do the project easily covered without having to dip into other budgeted areas?
At first, as you begin to learn how to perform an incremental cash flow analysis, you’ll have to focus on these challenges. Eventually, they’ll become habitual and part of your streamlined thought processes.
When you’ve mastered the incremental cash flow decision-making, you can move on to evaluating your total cash flow.
Related: A Simple Guide to Cash Flow Estimation
2. What is Total Cash Flow?
The cash flow in your business includes every business transaction you make. If it’s part of your receivables or payables, it’s part of cash flow, even if you haven’t gotten the money yet. This happens when businesses invoice their clients or work with a lot of purchase orders.
In the total cash flow of your upcoming bills and income, the paper numbers might show that your assets outweigh your expenses. But if any of the assets are from a sale that you won’t collect on until after the budgeting period, you won’t be able to use it.
In other words, what flows out needs to be covered by what is flowing in or already there.
Determining Total Cash Flow
Most businesses have multiple sources of revenue. Between investment interest, late fees you collect, and basic sales, there are many income streams going on. You’ll need to add them all to the total cash flow of your business.
When you analyze your total cash flow, you’re looking to find the total cumulative income received from a project. This formula is also helpful for checking the health of a business.
You can break this number down into two different formulas:
- Operating cash flow
- Business cash flow
Finding the Operating Cash Flow
When you want to get to the meat of your sales, the operating cash flow formula is helpful. First, you’ll need to decide what particular time period you want to estimate. You can have these broken down into monthly, quarterly, or annual analyses.
The formula looks like this:
Total Expected Receivables – Operating Expenses = Total Operating Cash Flow
The more specific you are with your dates and numbers, the more accurate the results will be.
Just as the goal is always to have a positive incremental cash flow, you want a positive total operating cash flow, too. This number is where you can really see if the project is worth the effort and expense.
Finding the Business Cash Flow
To check the health of your business in general, you can use a similar formula. The main difference is that here, you’ll include all your non-sales expenses and revenue, like interest and taxes.
The formula looks like this:
Total Receivables – Total Payables = Total Cash Flow
Choose the period you want to analyze and use the numbers from that time only in your formula. Don’t include any receivables or payables that aren’t sure to be part of the period in question.
It’s also essential to consider asset depreciation if you’re going to use it to lower your income tax amount. You can also include bad debts here.
You can now use both of these cash flow formulas to drive your future business decisions.
3. Using Cash Flow Numbers to Determine Investments
Every investment you make has a level of risk attached to it. In your business operations, you have to decide which risks are worth the potential payoff and which ones to avoid.
For instance, when you offer a discount rate, you’re risking the chance that the consumer might not order enough to cover costs.
The discounted cash flow analysis is a formula that you can use to decide if an upfront investment will result in a solid return through cash flows. You can learn more about this formula here.
A lot of companies use a discount rate to solicit business. The riskier the project, the higher the discount rate. But in order to gauge risk strategically, you need to know your incremental, operating, and total cash flows.
Is the Risk Worth the Investment?
Before you jump in and agree to a big project, there are some factors to consider.
What’s your average cost of capital going to be?
This is the money you’ll need to put the project together and the cost of using that cash.
Once you know the upfront cost and the estimated cash flow it should bring, you can determine how much of a discount you can offer. A cash flow statement template can guide you as you work through this process.
For example, the estimated value of cash flow on a project you were offered is $100,000. It will cost you $75,000 to complete it, with an initial outlay of half. The client is looking for the lowest bid.
You can aim for the $25,000 profit, taking the risk that they’ll choose you. Or you can give them a discount on the original project price. With the knowledge you have from the numbers you’ve run, you can decide how much of a discount is worth the work.
A 10% discount off $100,000 is going to save the client $10,000. It’s still going to cost you $75,000, though. Your net profit for the new project will be $15,000.
Is it worth it, especially if you have to cover the initial investment?
You now have the details to make an informed decision.
4. How To Increase Total and Incremental Cash Flow
The goal of every business is to make a profit, which means that the bottom line is to increase cash flow. You can do this by reducing your outlay and overhead, or you can bring in more money in other ways.
Tips To Boost Your Cash Flow
Ready to improve your incremental and total cash flow?
Try these tips to boost your numbers without cutting any costs:
Raise Your Prices
It’s the standard method of making more money, but it’s always a risk. Check the market conditions at the time to see if clients are willing to pay more. Even a 1% increase can generate a hefty amount of revenue. If you lose a lot of customers with your rate hike, though, it might not be worth it.
Change Your Invoicing System
Your business might be rolling in the dough on paper. If your clients aren’t paying their invoices, though, you don’t get to reap the benefits of the high Accounts Receivable report.
A few minor tweaks to your invoicing system can improve your receivables. Try offering a discount for clients who pay early or those that sign up for automated payments.
Charge a penalty for 30, 60, and 90+ late payments. Knowing that you will fine them — even just a few dollars — encourages many people to pay on time.
Avoid Slow Season Debt
Almost every business has a slow season. It’s easy to fall behind on your expenses when your income falls. But if you plan ahead during your peak periods, you can pay some costs early or put aside money for the lull.
This isn’t always possible, though, and sometimes, you need more money than you expected. Instead of waiting for clients to pay and falling into debt, use an alternative financial source for extra cash.
Accelerated invoicing through Now is a smart way to get working capital when you need it. You’re already owed the money. Now gives it to you upfront, minus a small fee. They collect the invoice from the customer, and you have the cash you need to run your business.
Diversify Your Inventory
You don’t have to follow the pack, but watching your competition can be helpful. If they’re offering something you don’t, you might consider branching out.
You can also check in with your current customers.
Do they have other needs you could meet if you increase your inventory slightly?
And is there anything in your product line that isn’t bringing you a profit?
It might be time to put those products out to pasture and focus on the lucrative services/items.
As a business owner, two beneficial traits you can have are flexibility and proactiveness. Both of these will put you ahead of the competition as you find ways to keep increasing your cash flow.
Related: How Much Inventory Is Too Much?
Conclusion
Owning a business is hard work, but those long hours and knowledge absorption from studying financial statements will pay off. As you learn how to analyze formulas like incremental and total cash flows, you’ll make better business decisions.
Soon, you can focus less on staying afloat and more on growth and expansion. All your financial success increases when you get into the nitty-gritty of your cash outflow and inflow.
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