And who doesn't love cash?
But what exactly is it, and how can you calculate it? Let’s break it down into bite-sized pieces, so even beginners can understand how to calculate CFROI.
CFROI was developed by Holt Value Associates in the 1980s to measure how effectively a company generates returns from its investments. Unlike traditional return metrics like Return on Equity (ROE) or Return on Invested Capital (ROIC), CFROI digs deeper by focusing on cash flow—because, as the saying goes, “Revenue is vanity, profit is sanity, but cash is king.”
CFROI’s value lies in its ability to highlight long-term operational performance. It helps investors compare a company’s internal cash-generating ability to its cost of capital, making it a valuable tool when you finally go on to learn
advanced business valuation techniques.
The CFROI Formula: Simple but Powerful
Ready for some numbers? The formula is surprisingly straightforward:
CFROI = Operating Cash Flow ÷ Capital Employed
Both parts of this equation need a bit of unpacking.
1. Operating Cash Flow
This is not your typical net income figure. Instead, it's cash generated from operations after accounting for expenses like depreciation and changes in working capital. You want the cash the company is truly producing—because, remember, cash is king.
2. Capital Employed
This term refers to the company's assets minus liabilities. Think of it as the money actively being used to generate returns.
Let’s say a company generates £10 million in operating cash flow and has £50 million in capital employed.
CFROI = £10m ÷ £50m = 20%
If the company's weighted average cost of capital (WACC) is 10%, then the difference (10%) indicates a solid potential for shareholder value growth.
Why Does CFROI Matter?
If you're wondering why CFROI deserves the hype, here’s why: it helps separate the signal from the noise.
Imagine you're going through the process of
valuing a business. It may be showing profits on paper, but those profits could be tied up in long-term contracts or depreciating assets. CFROI, however, looks at actual cash flow, which can reveal the company's real financial health.
Forecasting with CFROI
To take it a step further, CFROI isn't just a snapshot; it can also be used for forecasting. Here’s where things get a bit more sophisticated:
- Forecast Cash Flows: Project cash flow year by year.
- Estimate Asset Life: Consider both the present value of assets and future values, especially non-depreciating assets like land.
Companies with shorter lifespans or industries facing rapid change (hello, tech and blockchain!) may see reduced CFROI due to quicker declines in asset value.
CFROI vs. Other Metrics
It's also important to know how CFROI stacks up against other return metrics:
While traditional metrics like ROE or ROIC are still valuable, they focus heavily on accounting profits. CFROI, on the other hand, zeroes in on cash flow and long-term performance.
Then there’s
Deutsche Bank’s CROCI (Cash Return on Capital Invested), which includes external funding sources but skips internal funding—an oversight that CFROI avoids. In simpler terms, CFROI is like looking under the hood of the car, rather than just admiring the shiny exterior.
How to Dive Deeper into Business Valuations
CFROI is a cash-focused return metric developed in the 1980s. It measures cash flow as a percentage of capital employed. It’s ideal for advanced business valuations because it focuses on long-term value generation. CFROI helps investors distinguish between short-term profits and sustainable cash generation.
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FAQ
Is CFROI a percentage?
Yes, CFROI (Cash Flow Return on Investment) is expressed as a percentage. It represents the cash flow a business generates relative to its capital employed. The formula is Operating Cash Flow ÷ Capital Employed, giving you a percentage that indicates the return a company is achieving from its investments. If a company has a CFROI of 15%, it means it's generating 15% in cash flow for every dollar or pound invested.