Funds From Operations (FFO) to Total Debt Ratio

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What is the ratio of funds from operations (FFO) to total debt?

The ratio of operating funds (FFO) to total debt is a leverage ratio that a rating agency or investor can use to assess a company’s financial risk. The ratio is a measure comparing profit from net operating income plus depreciation, amortization, deferred income taxes and other non-cash items to long-term debt plus current maturities, commercial paper and other short-term loans. The costs of ongoing capital projects are not included in total debt for this ratio.

Formula and Calculation of Funds From Operations (FFO) to Total Debt Ratio

The FFO on total debt is calculated as follows:

Free cash flow / Total debt

Or:

  • Free cash flow is net operating income plus depreciation, amortization, deferred income taxes and other non-cash items.
  • Total debt includes all long-term debt plus current maturities, commercial paper and short-term loans.

Key points to remember

  • Funds From Operations (FFO) to Total Debt is a leverage ratio that is used to assess the risk of a business, real estate investment trusts (REITs) in particular.
  • The FFO to Total Debt ratio measures a company’s ability to repay its debt using only net operating income.
  • The lower the FFO / Total Debt ratio, the greater the company’s leverage, a ratio less than one indicating that the business may need to sell some of its assets or take out additional loans to stay in business.

What Funds From Operations (FFO) Over Total Debt Ratio Can Tell You

Funds from operations (FFO) is the measure of cash flow generated by a real estate investment trust (REIT). Funds include the money the company receives on its inventory sales and the services it provides to its customers. Generally Accepted Accounting Principles (GAAP) require that REITs amortize their investment properties over time using one of the standard amortization methods, which can distort the true performance of the REIT. This is because many investment properties gain in value over time, making depreciation inaccurate in describing the value of a REIT. Depreciation and amortization must therefore be added to net income to reconcile this issue.

The FFO to Total Debt ratio measures a company’s ability to repay its debt using only net operating income. The lower the ratio of FFO to total debt, the more the company is in debt. A ratio less than 1 indicates that the business may need to sell some of its assets or take out additional debt to stay afloat. The higher the ratio of FFO to total debt, the stronger the position of the company to pay its debts from its operating profit, and the lower the credit risk of the company.

Since debt-financed assets typically have a useful life of more than one year, the FFO measure on total debt is not intended to assess whether a company’s annual FFO fully covers debt, it is that is, a ratio of 1, but rather if it has the capacity to service the debt in a prudent time frame. For example, a ratio of 0.4 implies the ability to fully service the debt in 2.5 years. Businesses may have resources other than operating funds to repay their debts; they can take out additional debt, sell assets, issue new bonds or issue new shares.

For businesses, the Standard & Poor’s credit agency considers that a business with an FFO / total debt ratio greater than 0.6 presents minimal risk. A company with modest risk has a ratio of 0.45 to 0.6; one at intermediate risk has a ratio of 0.3 to 0.45; the one that presents a significant risk has a ratio of 0.20 to 0.30; one with aggressive risk has a ratio of 0.12 to 0.20; and the high risk one has an FFO / total debt ratio of less than 0.12. However, these standards vary by industry. For example, an industrial company (manufacturing, services or transportation) may need an FFO to total debt ratio of 0.80 to achieve an AAA rating, the highest credit rating.

Limits on the use of the FFO / Total debt ratio

The FFO to total debt alone does not provide enough information to decide the financial position of a company. Other key leverage ratios for assessing a company’s financial risk include the debt-to-EBITDA ratio, which tells investors how many years it would take the company to pay off debt, and the total debt-to-capital ratio, which tells investors how a company is financing its operations.

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John A. Bogar

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