CFROI (Cash Flow Return on Investment)

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 Flow Cash 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.read more 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 Analysis Cash 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.read more) –

Operating Cash Flow (OCF) = Net Income + Non-Cash Expenses + Changes in Working Capital.

Capital Employed (CE)

Now let’s look at the Capital EmployedCapital Employed Capital 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."read more (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 Rate The 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.read more. 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.

Examples

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

Details	In US $
Net Income	600,000
Depreciation & amortization	56,000
Deferred TaxesDeferred Taxes Deferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more	6,500
Increase in Accounts ReceivablesAccounts Receivables Accounts 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.read more	4,000
Decrease in Inventories	6,000
Decrease in Account PayablesAccount Payables Accounts 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.read more	9,000
Increase in Accrued Interest Payable	3,200
Profit on Sale of Property	12,000
Total Assets	32,00,000
Current Liabilities	400,000
Equity	20,00,000
Debt	800,000
Cost of EquityCost Of Equity Cost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more	4%
Cost of DebtCost Of Debt Cost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more	6%
Corporate Tax Rate	30%

We have the above information available. First, we will calculate the operating cash flowCalculate The Operating Cash Flow The 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.read more.

Q Company

Cash Flow Statement for the year 2016

Details	In US $
Net Income	600,000
(+) Non-cash expenses
Depreciation & amortization	56,000
Deferred Taxes	6,500
(+) Changes in Working Capital
Increase in Accounts ReceivablesAccounts Receivables Accounts 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.read more	(4,000)
Decrease in Inventories	6,000
Decrease in Account PayablesAccount Payables Accounts 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.read more	(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
Capital Employed	28,00,000
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 (E)	20,00,000
Debt (D)	800,000
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%
WACC (B)	4.06%
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 Ratios Accounting 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.read more 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.

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