Cash Flow Return on Investment (CFROI)

Introduction

Cash Flow Return on Investment (CFROI) is a financial metric that provides a comprehensive measure of a company's financial performance. It is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings. CFROI is used by investors and financial analysts to determine the profitability and value of a company, taking into account the cash flow it generates relative to the capital invested in the business.

What is Cash Flow Return on Investment (CFROI)?

CFROI is a refinement of other financial metrics such as Return on Investment (ROI) and Internal Rate of Return (IRR). It is a measure of a company's economic performance and is used to compare the relative profitability of companies. The CFROI metric is especially useful in sectors where companies make significant investments in long-term assets.

The CFROI metric is based on the principle that a company's value is determined by the cash flows it generates. It is a measure of the cash returns a company generates on its invested capital, which includes equity and interest-bearing debt.

The CFROI Formula

The formula to calculate CFROI is as follows:

CFROI = (Gross Cash Flow / Gross Investment) x 100%

Where:

• Gross Cash Flow is the cash generated by the company's operations before interest expenses and taxes. It is calculated by adding back non-cash expenses (like depreciation and amortization) to net income.

• Gross Investment is the total capital invested in the company. It includes both equity capital (common and preferred shares) and interest-bearing debt.

How to Calculate CFROI

Here is a step-by-step guide on how to calculate CFROI:

• Calculate Gross Cash Flow: Start by determining the company's net income, which can be found on the income statement. Then, add back any non-cash expenses such as depreciation and amortization, which are also found on the income statement.

• Calculate Gross Investment: Next, determine the total capital invested in the company. This includes the equity capital (common and preferred shares) and any interest-bearing debt. These figures can be found on the balance sheet.

• Calculate CFROI: Finally, divide the gross cash flow by the gross investment and multiply by 100 to get the CFROI as a percentage.

The Importance of CFROI

CFROI is a valuable tool for investors and financial analysts because it provides a clear picture of a company's ability to generate cash returns on its invested capital. It is especially useful for comparing the profitability of companies within the same industry.

CFROI is also beneficial for small and medium-sized businesses (SMBs) as it helps them understand their financial performance in terms of cash flow, which is often a more critical measure for them than earnings. By focusing on cash flows, SMBs can better manage their resources and make more informed investment decisions.

In conclusion, CFROI is a robust financial metric that provides a comprehensive measure of a company's financial performance. By focusing on cash flows rather than earnings, it offers a more accurate picture of a company's profitability and value.

Sources

• Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of any Asset. John Wiley & Sons.

• Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and Managing the Value of Companies. John Wiley & Sons.

• Palepu, K., Healy, P., & Peek, E. (2010). Business Analysis and Valuation: Using Financial Statements. Cengage Learning EMEA.