Cash Flow Returns

It is a truism that earnings are not cash flows and the item that is viewed as the main reason for the difference between earnings and cash flows is depreciation and amortization. While depreciation is an accounting expense, depressing earnings, it is not a cash expense. Some firms that look like they are under performing based upon accounting returns may look much better when we look at the cash flows that they generate, and other firms that seem to be superior performers, based upon accounting earnings, may lag when judged based upon cash flows. In this section, we will consider two variations of returns that consider cash flows instead of earnings, the first a simple extension of return on invested capital and the other a more complicated version of time value adjusted cash flows.

Cash Earnings Measures

If depreciation and amortization are accounting expenses but not cash expenses, a simple version of the after-tax operating cash flow for a firm can be computed as follows:

Converting this operating cash flow measure into a return is difficult, because the invested capital that we used as the denominator in the conventional measure of return on capital is net of depreciation and amortization charges over previous years. In the 1990s, Deutsche Bank developed a measure of cash flow return on capital that tried to eliminate this inconsistency by using the gross investment in assets (obtained by adding back accumulated depreciation to the net investment value) to estimate the capital investment. Their measure of return, titled Cash flow Return on Capital Invested (CROCI) was computed as follows:

where,

Consider a simple illustration to make this point. Assume that a firm reports $100 million in operating income, after depreciation charges of $30 million, and that the tax rate is 40%. Furthermore, assume that this firm has net fixed assets of $ 500 million (with accumulated depreciation of $150 million) and non-cash working capital of $ 100 million. The return on capital and CROCI can be computed as follows:

For this firm, the cash flow return on capital exceeds the return on capital.10

By adding depreciation back to after-tax operating income in the numerator and the accumulated depreciation to capital invested in the denominator, proponents of this measure argue that they were being consistent and that the resulting return on capital is a cash flow version of the accounting return on capital, and is comparable to the cost of capital. They also posit that this return is less susceptible to accounting choices on depreciation. For instance, choosing a more accelerated depreciation method would leave this return unaffected while creating large changes in the conventional return on capital.

10 The relationship between return on capital and cash flow return on capital will be determined by the ratio of current depreciation to accumulated depreciation. If this ratio is greater than the current return on capital, the cash flow return on invested capital will exceed the return on capital. In this example, for instance, the depreciation/ accumulated depreciation ratio is 20% which exceeds the return on capital of 10%.

See Technical Indicators