What is Cash Flow Return on Investment (CFROI)?
CFROI (or Cash Flow Return on Investment) is the Internal Rate of ReturnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected. (IRR) as it is compared with the hurdle rate to understand whether the product/investment is doing well.
- HOLT Value Associates developed it. This measure allows investors to go into the company’s internal structure to find out how cash is created in the organization.
- It helps you understand how a company finances its operations and how financial providers are being paid. Moreover, Cash Flow ROI also takes inflation into account.
- CFROI is a valuation model that assumes that the stock market decides the prices based on the company’s cash flow. And it doesn’t consider the company’s performance or earnings.
[Note: If you are wondering what hurdle rate is, here’s the brief info: hurdle rate is the minimum rate the company expects to earn when the company invests in a project. Usually, investors calculate the weighted average cost of capital (WACC) and use it as a hurdle rate.]
Table of contents
- CFROI, or Cash Flow Return on Investment, is the Internal Rate of Return (IRR) developed by HOLT Value Associates. It is compared with the difficulty rate to determine if the product/investment performs well. Moreover, it allows investors to examine the company’s internal structure to analyze how cash is made.
- It also helps to know how a company funds its business activities and how financial providers are paid off. It also considers inflation.
- This valuation model believes that the stock market fix prices depending on the company’s cash flow and does not consider the company’s conduct or profit.
Cash Flow Return on Investment formula
CFROI Formula = Operating Cash Flow (OCF) / Capital Employed
To calculate CFROI, we need to understand both OCF and CE. Let’s understand them one by one.
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Operating Cash Flow (OCF)
In simple terms, operating cash flowOperating Cash FlowCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. is the amount of cash that comes in after paying operating expenses for the company. So we will first look at the net income. And make the following adjustments (according to the Indirect Method of Cash Flow AnalysisCash Flow AnalysisCash flow analysis refers to examining or analyzing the company's different cash inflows and outflows during the period under consideration from the various activities, including operating activities, investing activities, and financing activities.) –
Operating Cash Flow (OCF) = Net Income + Non-Cash Expenses + Changes in Working Capital.
Capital Employed (CE)
Companies use two usual measures to calculate capital employed. We need to remain consistent in our approach no matter which we use. Here are two ways to find out capital employed. Now let’s look at the Capital EmployedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital." (CE).
- Capital Employed = Fixed Assets + Working Capital
- Capital Employed = Total Assets – Current Liabilities
The second method is easier, and in the example section, we will use the second method to ascertain the capital employed.
Cash Flow Return on Investment – Starbucks Example
As an example, let us calculate the CFROI of Starbucks
From the above chart, we have the following –
- Operating Cash Flow (2018) = $11.94 billion
- Capital Employed (2018) = $18.47 billion
- CFROI Formula = Operating Cash Flow / Capital Employed = $11.94 / $18.47 = 64.6%
How to Interpret CFROI?
Cash Flow Return on Investment can’t be interpreted without comparing it to the hurdle rateHurdle RateThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate.. Usually, the hurdle rate is the Weighted Average Cost of CapitalWeighted Average Cost Of CapitalThe weighted average cost of capital (WACC) is the average rate of return a company is expected to pay to all shareholders, including debt holders, equity shareholders, and preferred equity shareholders. WACC Formula = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * (1-Tax Rate)] (WACC).
Once the CFROI is calculated, it is compared with WACC, and then the Net CFROI is calculated.
Here’s how you can calculate Net CFROI –
Net CFROI = Cash Flow Return on Investment (CFROI) – Weighted Average Cost of Capital (WACC)
- If the Net CFROI is positive (i.e., Net CFROI > WACC), then it increased the value of shareholders and
- if Net CFROI is negative (i.e., Net CFROI < WACC), then it decreased the value of shareholders.
Ms. Shweta has been thinking of investing in Q Company. But before investing, she wants to know whether Q Company would be able to appreciate her value as a shareholder. So she decided to find out Cash Flow, Return on Investment, and Net CFROI. She has the following information at her disposal.
Q Company at the end of 2016
We have the above information available. First, we will calculate the operating cash flowCalculate The Operating Cash FlowThe operating cash flow formula depicts the operational cash flow acquired after deducting the operating expenses from the total revenue. It can also be evaluated as the aggregate of net income, changes in assets and liabilities and non-cash expenses..
Cash Flow Statement for the year 2016
We have one component of the CFROI. We need to calculate another one, i.e., capital employed.
|Details||In US $|
|Total Assets (A)||32,00,000|
|Current Liabilities (B)||400,000|
|Capital Employed (A – B)||28,00,000|
So, here’s the Cash Flow Return on Investment of Q Company –
Cash Flow Return on Investment Formula = Operating Cash Flow (OCF) / Capital Employed
|Details||In US $|
|Cash flow from Operating Activities (A)||6,46,700|
|Cash Flow Return on Investment (A / B)||23.10%|
To know the hurdle rate and compare Cash Flow Return on Investment with it, we need first to compute WACC and then find out Net.
Here’s how we will calculate WACC.
WACC = E/V * Re + D/V * Rd * (1 – TC)
|Details||In US $|
|Equity + Debt (V)||28,00,000|
|E / V||0.71|
|Cost of Equity||4%|
|D / V||0.29|
|Cost of Debt||6%|
|Corporate Tax Rate||30%|
Putting the above value in the equation, we get –
- WACC = 0.71 * 0.04 + 0.29 * 0.06 * (1 – 0.30)
- WACC = 0.0284 + 0.01218
- WACC = 0.04058 = 4.06%
Then, the Net Cash Flow Return on Investment is –
|Details||In US $|
|Cash Flow Return on Investment (A)||23.10%|
|Net Cash Flow Return on Investment (A – B)||19.04%|
From the above calculation, Shweta is now confident that Q Company will be able to appreciate the investment she would be making. As a result, she would go ahead and invest in the company.
In the final analysis
CFROI is one of the best measures if you want to know an accurate picture of how a company is doing. Other accounting ratiosAccounting RatiosAccounting ratios measure the company's financial health by comparing the various elements of the financial statements to gauge the organization's progress over the period. There are four types of accounting ratios- liquidity, solvency, profitability and activity ratios. work, but they are based on the flawed idea that “more profit means better resource management and better returns.” But in the true sense, how much cash is coming in and how much is going out will always decide how a company is doing in terms of performance in the market. Every investor should calculate CFROI and Net Cash Flow Return on Investment before investing in any company.
Frequently Asked Questions (FAQs)
As a capital budgeting method, the limitation of the CFROI is that it needs to count the time value of money. Thus, it does not follow the discounted cash flow idea that today’s dollar is more beneficial than the future’s.
The advantage of CFROI is that it has the corporation’s capability to create cash flow. Moreover, it is inflation-adjusted and can be calculated at the divisional (Strategic Business Unit) level and utilized for privately held companies.
The discounted cash flow ROI shows the profit’s net present value (ROI) divided by the cost’s net present value. In addition, this approach considers the future cash flow’s present value, permitting future cash flows to be similar to current cash flows.
This has been a guide to what is CFROI and its meaning? Here we discuss Cash Flow Return on Investment Formula and its interpretation and practical examples (Starbucks). You may learn more about Financial Statement analysis from the following articles –