What it means
Accounting returns are easy to calculate and easy to mislead. Return on equity rises when debt replaces equity; return on assets rises as assets depreciate and their book value falls, so an old plant shows a high return simply because its denominator has shrunk; acquisitions inflate the asset base with goodwill; inflation makes old assets look cheap; and companies that lease rather than own, or expense rather than capitalise, show different returns for the same economics.
CFROI attempts to remove these effects and measure the return an investor would actually have earned on the cash put into the business. The full method proceeds in steps.
Gross cash flow is calculated: operating profit after tax, plus depreciation and amortisation, plus rental expense on operating leases (treated as if the assets were owned), plus other non-cash charges, adjusted for inflation gains and losses on monetary items. Gross investment is calculated: the historic cost of depreciating assets grossed up by inflation since purchase, plus non-depreciating assets (land, working capital, investments), plus capitalised operating leases, minus non-debt liabilities.
The asset life is estimated from gross depreciating assets divided by annual depreciation. The non-depreciating assets are treated as released at the end of the life.
CFROI is then the internal rate of return of a project that invests the gross investment today, receives the gross cash flow each year for the asset life, and recovers the non-depreciating assets at the end. Because the inputs are inflation-adjusted, the result is a real rate, compared with a real cost of capital, typically around 5% to 7%.
Simplified versions divide gross cash flow by gross investment, which approximates the full calculation for long-lived assets, or use free cash flow over invested capital. They lose some comparability but are far easier to compute and are widely used internally.
The measure's value is comparability. Two companies with the same accounting return may have very different CFROIs if one has old assets and the other new, or one leases and the other owns, or one has grown by acquisition and the other organically.
CFROI puts them on the same footing. It also behaves sensibly over time: a company's CFROI does not rise simply because its assets age, so a rising CFROI means genuine improvement.
The costs are complexity and judgement. Inflation adjustment requires asset age profiles that are not always disclosed; capitalising leases requires assumptions; and the asset life estimate is sensitive to the mix of assets.
Analysts using CFROI rely on standardised databases; companies using it internally simplify. The concept nonetheless underlies much modern thinking about value creation: a business creates value only when the cash return on the cash invested exceeds what investors could earn elsewhere at equal risk, and CFROI is the most direct attempt to measure that.
In practice
Real-world examples.
Example
An equity analyst ranks fifty industrial companies by CFROI and finds that the top quartile trade at twice the enterprise value to gross investment of the bottom quartile.
Example
A conglomerate uses CFROI to compare its divisions, discovering that its "highest return" division by return on assets is merely its oldest.
Example
A private equity firm evaluates a target on CFROI to avoid overpaying for accounting returns produced by fully depreciated plant.
Think of it
“CFROI measures the cash return you get on every dollar invested in the business-a real-money ROI.
Formula
Calculation
Simplified CFROI = Gross cash flow / Gross investment
Full CFROI: the rate r that solves
Gross investment = Sum over years 1 to n of [Gross cash flow / (1 + r) to the power t] + Non-depreciating assets / (1 + r) to the power n
where n = asset life = Gross depreciating assets / Annual depreciation
Gross Cash Flow = Operating profit after tax + Depreciation and amortisation + Operating lease rental (if leases not on balance sheet) + Other non-cash charges
Gross Investment = Gross depreciating assets (inflation-adjusted) + Working capital + Land and other non-depreciating assets + Capitalised leases
Worked example. A food processing company reports: operating profit $18,000,000; tax at 25%; depreciation $9,000,000; gross property, plant and equipment at cost $120,000,000 (net book value $55,000,000), average age 7 years, with inflation over that period adding about 18% to replacement cost; land at cost $8,000,000; net working capital $14,000,000; no leases.
Gross cash flow = $18,000,000 x 0.75 + $9,000,000 = $22,500,000
Gross depreciating assets, inflation-adjusted = $120,000,000 x 1.18 = $141,600,000
Non-depreciating assets = land $8,000,000 + working capital $14,000,000 = $22,000,000
Gross investment = $141,600,000 + $22,000,000 = $163,600,000
Asset life = $120,000,000 / $9,000,000 = 13.3 years, say 13
Simplified CFROI = $22,500,000 / $163,600,000 = 13.8% (a gross yield, overstating the true return because it ignores that the depreciating assets are consumed)
Full CFROI: find r such that $163,600,000 = $22,500,000 x annuity factor (13 years, r) + $22,000,000 / (1 + r) to the power 13. At r = 10%: $22,500,000 x 7.103 + $22,000,000 x 0.290 = $159,800,000 + $6,400,000 = $166,200,000, slightly above $163,600,000. At r = 11%: $22,500,000 x 6.750 + $22,000,000 x 0.258 = $151,900,000 + $5,700,000 = $157,600,000, below. CFROI is about 10.3%, a real return.
Comparison with accounting returns: return on net assets = $13,500,000 after-tax operating profit / ($55,000,000 + $8,000,000 + $14,000,000) = 17.5%. The accounting return is inflated by the depreciated asset base; CFROI at 10.3% is the economic return. Against a real cost of capital of 6%, the company creates value, but by less than the 17.5% suggests.
Comparison with a competitor: a rival with newer plant (average age 2 years, net book value $100,000,000 on gross cost $115,000,000) shows a return on net assets of 12% but a CFROI of 10.8%. On accounting returns the first company looks far better; on CFROI they are almost identical, and the rival's slightly higher figure reflects better real efficiency that the older company's depreciated asset base hides.Case study
Seen in the real world.
A diversified group allocated capital to its four divisions partly on return on capital employed, which ranged from 9% for its newest division (a recently built logistics network) to 28% for its oldest (a chemicals plant built thirty years earlier). The chemicals division received the most investment approval and the logistics division the least. A new chief financial officer had CFROI calculated for each division.
The chemicals plant's gross assets, inflation-adjusted, were four times their book value; its CFROI was 7%, barely above the group's real cost of capital, and its high accounting return was the arithmetic of a denominator that had been depreciated almost to nothing. The logistics division's CFROI was 11%: its assets were new, so book and gross values were close, and the accounting return had understated it. The capital allocation was reversed.
Over the following five years the logistics division doubled and the chemicals division, whose plant was reaching the end of its life, was sold to a buyer who intended to rebuild it. The chief financial officer's board paper noted that the group had spent a decade allocating capital to the division that had stopped investing, because not investing was what made its accounting return look high.
Watch out
Common mistakes.
- Comparing return on assets across companies with different asset ages, which rewards old, depreciated plant. CFROI exists to correct this.
- Using the simplified gross yield (gross cash flow over gross investment) as if it were a true return; it ignores the consumption of depreciating assets and overstates the rate.
- Treating CFROI as precise. The inflation adjustment and asset life are estimates; the value is in comparability and trend, not the second decimal.
Questions
People also ask.
How does CFROI differ from ROIC?
Return on invested capital uses accounting profit and book capital. CFROI uses gross cash flow and inflation-adjusted gross investment, treating the business as a project with a finite life, and produces a real rate of return.
What is a good CFROI?
Above the real cost of capital, typically 5% to 7%. Sustained CFROI above 10% is strong; the best companies hold 15% or more for long periods.
Is CFROI practical for a private company?
The simplified version is; the full version requires asset age data the company holds internally and is easier for it than for outside analysts. It is most useful for comparing divisions or assessing acquisition targets with old plant.
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