What Is Funds From Operations (FFO) to Total Debt Ratio?
The funds from operations (FFO) to total debt ratio is a leverage ratio that a credit rating agency or an investor can use to evaluate a company’s financial risk. The ratio is a metric comparing earnings from net operating income plus depreciation, amortization, deferred income taxes, and other noncash items to long-term debt plus current maturities, commercial paper, and other short-term loans. Costs of current capital projects are not included in total debt for this ratio.
Formula and Calculation of Funds From Operations (FFO) to Total Debt Ratio
FFO to total debt is calculated as:
Free cash flow / Total debt
- Free cash flow is net operating income plus depreciation, amortization, deferred income taxes, and other noncash items.
- Total debt is all long-term debt plus current maturities, commercial paper, and short-term loans.
- Funds from operations (FFO) to total debt is a leverage ratio that is used to assess the risk of a company, real estate investment trusts (REITs) in particular.
- The FFO to total debt ratio measures the ability of a company to pay off its debt using net operating income alone.
- The lower the FFO to total debt ratio the more leveraged the company is, where a ratio below one indicates the company may have to sell some of its assets or take out additional loans to stay in business.
What Funds From Operations (FFO) To Total Debt Ratio Can Tell You
Funds from operations (FFO) is the measure of cash flow generated by a real estate investment trust (REIT). The funds include money the company collects from its inventory sales and services it provides to its customers. Generally Accepted Accounting Principles (GAAP) require REITs to depreciate their investment properties over time using one of the standard depreciation methods, which can distort the true performance of the REIT. This is because many investment properties increase in value over time, making depreciation inaccurate in describing the value of a REIT. Depreciation and amortization must, thus, be added back to net income to reconcile this issue.
The FFO to total debt ratio measures the ability of a company to pay off its debt using net operating income alone. The lower the FFO to total debt ratio, the more leveraged the company is. A ratio lower than 1 indicates the company may have to sell some of its assets or take out additional loans to keep afloat. The higher the FFO to total debt ratio, the stronger the position the company is in to pay its debts from its operating income, and the lower the company’s credit risk.
Since debt-financed assets generally have useful lives greater than a year, the FFO to total debt measure is not meant to gauge whether a company’s annual FFO covers debt fully, i.e. a ratio of 1, but rather, whether it has the capacity to service debt within a prudent timeframe. For example, a ratio of 0.4 implies the ability to service debt fully in 2.5 years. Companies may have resources other than funds from operations for repaying debts; they might take out an additional loan, sell assets, issue new bonds, or issue new stock.
For corporations, the credit agency Standard & Poor’s considers a company with an FFO to total debt ratio of more than 0.6 to have minimal risk. A company with modest risk has a ratio of 0.45 to 0.6; one with intermediate-risk has a ratio of 0.3 to 0.45; one with 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 one with high risk has an FFO to total debt ratio below 0.12. However, these standards vary by industry. For example, an industrial (manufacturing, service, or transportation) company might need an FFO to total debt ratio of 0.80 to earn an AAA rating, the highest credit rating.
Limitations of Using FFO to Total Debt Ratio
FFO to total debt alone does not provide enough information to decide a company’s financial standing. Other related, key leverage ratios for evaluating a company’s financial risk include the debt to EBITDA ratiowhich tells investors how many years it would take the company to repay its debts, and the debt to total capital ratiowhich tells investors how a company is financing its operations.