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.read more (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.]

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.

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.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 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.read more) –

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.“read more (CE).

  • Capital Employed = Fixed Assets + Working CapitalCapital 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 billionCapital Employed (2018) = $18.47 billionCFROI 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.read more. 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)]read more (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 andif 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

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.read more.

Q Company

Cash Flow Statement for the year 2016

We have one component of the CFROI. We need to calculate another one, i.e., capital employed.

So, here’s the Cash Flow Return on Investment of Q Company –

Cash Flow Return on Investment Formula = Operating Cash Flow (OCF) / Capital Employed

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)

Putting the above value in the equation, we get –

  • WACC = 0.71 * 0.04 + 0.29 * 0.06 * (1 – 0.30)WACC = 0.0284 + 0.01218WACC = 0.04058 = 4.06%

Then, the Net Cash Flow Return on Investment is –

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.read more 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.

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

  • ROE FormulaDuPont ROE