What is Cash Flow Return on Investment (CFROI)?
CFROI (or Cash Flow Return on Investment) is the Internal Rate of Return (IRR) of the company as it is compared with the hurdle rate to understand whether the product/investment is doing well.
- It was developed by HOLT Value Associates. This measure allows investors to go into the internal structure of the company 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 cash flow of the company. And it doesn’t take into account the performance or earnings of the company.
[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 into a project. Usually, investors calculate the weighted average cost of capital (WACC) and use it as a hurdle rate.]
Cash Flow Return on Investment formula
CFROI Formula = Operating Cash Flow (OCF) / Capital Employed
To be able to calculate CFROI, we need to understand both OCF and CE. Let’s understand them one by one.
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)
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) of the company. Companies use two usual measures to calculate capital employed. Here are two ways to find out capital employed. No matter which we use, we need to remain consistent in your approach.
- 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 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 Capital (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
|Details||In US $|
|(+) Non-cash expenses|
|Depreciation & amortization||56,000|
|(+) Changes in Working Capital|
|Increase in Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.||(4,000)|
|Decrease in Inventories||6,000|
|Decrease in Account PayablesAccount PayablesAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.||(9,000)|
|Increase in Accrued Interest Payable||3,200|
|Profit on Sale of Property||(12,000)|
|Cash flow from Operating Activities||6,46,700|
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 to compare Cash Flow Return on Investment with it, we need to first 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, and 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 actual 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.
CFROI (Cash Flow Return on Investment) Video
This has been a guide to what is CFROI and its meaning? Here we discuss Cash Flow Return on Investment Formula and its interpretation along with practical examples (Starbucks). You may learn more about Financial Statement analysis from the following articles –