What it means
Ordinary return measures, such as return on assets, rely on accounting profit and on asset values that have been written down by depreciation. That can make an old, heavily depreciated business look better than it really is.
CFROI tries to fix this by using cash flow and the inflation-adjusted, original cost of assets. In the simplest form the measure takes gross cash flow, which is profit plus depreciation and other non-cash charges, and divides it by gross investment, which is the total original cost of the assets used.
The more complete version, developed by the HOLT valuation group, also adjusts for inflation and treats assets as having a limited life, so it is calculated as an internal rate of return. The result is compared with a hurdle, usually the company's cost of capital, meaning the average return investors expect.
If CFROI is above that hurdle, the business is creating value, and if it is below, it is destroying value even when reported profit is positive. Managers use the measure to compare divisions, assess capital projects and set incentives.
A division with high accounting profit but low CFROI might be sitting on an expensive asset base that is earning too little cash. The nuance is that the full calculation is complex and depends on assumptions about asset lives and inflation.
For general business use, many teams use the simplified version, which is easy to explain but should be labelled as an approximation. A practical way to read the number is to look at the spread between CFROI and the cost of capital and not at CFROI on its own.
A spread of three percentage points on a large asset base is worth far more than a spread of ten points on a small one. Managers therefore multiply the spread by the invested amount to convert it into a dollar figure of value created each year.
In practice
Real-world examples.
Example
A packaging manufacturer reviews two plants. Plant A has a low book value because its equipment is old, but its CFROI is 7% against a cost of capital of 9%. The group decides that Plant A needs new investment or closure.
Example
A software firm with very few physical assets reports a CFROI of 35%. Its board uses the figure to justify spending more on product development, because each extra dollar invested has historically earned well above the cost of capital.
Example
A retail chain compares its stores on CFROI instead of profit. A city centre store with high sales turns out to have a CFROI of only 6% because of its large fit-out costs. A smaller suburban store earns 15% on a much lower investment.
Formula
Calculation
Simplified CFROI = gross cash flow / gross investment
where gross cash flow = after-tax operating profit + depreciation, and gross investment = original cost of assets before depreciation.
A bottling company has after-tax operating profit of $2,000,000 and depreciation of $1,000,000, so gross cash flow = 2,000,000 + 1,000,000 = $3,000,000. The original cost of its plant, equipment and working capital is $25,000,000.
Simplified CFROI = 3,000,000 / 25,000,000 = 12%. If the company's cost of capital is 9%, the spread is 12% - 9% = 3%, which suggests it earns more than the return investors require. Each year, the extra return is worth about 25,000,000 x 3% = $750,000.Case study
Seen in the real world.
Brightmoor Logistics is an illustrative, fictional haulage business with three regional depots. Its accounts showed each depot making a profit, so management assumed all three deserved equal investment.
The finance team calculated a simplified CFROI for each depot. The northern depot earned 14% on its original investment, the central depot earned 10%, and the southern depot earned only 6%, below the group's 9% cost of capital.
Management stopped adding vehicles to the southern depot and redirected funds to the north. Within two years group cash flow improved even though total revenue grew slowly. The illustrative point is that a profitable unit can still fail to earn its keep once the money tied up in it is considered.
Watch out
Common mistakes.
- Using depreciated book value in the denominator, which flatters older businesses and defeats the purpose of the measure.
- Comparing CFROI to an interest rate instead of to the cost of capital, which includes the return required by shareholders.
- Presenting the simplified version as if it were the full inflation-adjusted calculation.
Questions
People also ask.
How is CFROI different from return on assets?
Return on assets uses accounting profit and net book value, whereas CFROI uses cash flow and the gross, original cost of assets.
What counts as a good CFROI?
One that comfortably exceeds the cost of capital, but the right level depends on the industry and the risk involved.
Can I use it for a single project?
Yes, in simplified form, by dividing the project's annual cash flow by the total amount invested, although a full project appraisal would also use discounting.
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