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 the 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 Return on Investment also takes inflation into account.
- CFROI is a valuation model that assumes that 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 flow 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 do the following adjustments (according to the Indirect Method of Cash Flow Analysis) –
Operating Cash Flow (OCF) = Net Income + Non-Cash Expenses + Changes in Working Capital.
Capital Employed (CE)
Now let’s look at the Capital Employed (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 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 hurdle 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.
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 Taxes | 6,500 |
Increase in Accounts Receivables | 4,000 |
Decrease in Inventories | 6,000 |
Decrease in Account Payables | 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 Equity | 4% |
Cost of Debt | 6% |
Corporate Tax Rate | 30% |
We have the above information available. First, we will calculate the operating cash flow (OCF).
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 Receivables | (4,000) |
Decrease in Inventories | 6,000 |
Decrease in Account Payables | (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 into 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 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 into any company.
CFROI (Cash Flow Return on Investment) Video
Recommended Articles
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 –