## What is Cash Flow Return on Investment (CFROI)?

CFROI (or Cash Flow Return on Investment) is the Internal Rate of Return (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

### Key Takeaways

- 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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### CFROI (Cash Flow Return on Investment) Explained in Video

#### 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 make 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)

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 Employed (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 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.

**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 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 (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. 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 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)

**What is the limitation of the CFROI as a capital budgeting method?**

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.

**What are the advantages of CFROI?**

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.

**What is discounted cash flow ROI?**

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.

### 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 and practical examples (Starbucks). You may learn more about Financial Statement analysis from the following articles –