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.
Breaking down Funds From Operations (FFO) To Total Debt Ratio
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. It is calculated as Net Income + Depreciation + Amortization - Gains on Sale of Property. Since Generally Accepted Accounting Principles (GAAP) require REITs to depreciate their investment properties over time using one of the standard depreciation methods, the true performance of the REIT may be distorted. 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, e.g., a ratio of 100, but rather, whether it has the capacity to service debt within a prudent timeframe, e.g., a ratio of 40, which 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 60 to have minimal risk. A company with modest risk has a ratio of 45 to 60; one with intermediate-risk has a ratio of 30 to 45; one with significant risk has a ratio of 20 to 30; one with aggressive risk has a ratio of 12 to 20; and one with high risk has an FFO to total debt ratio below 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 80 to earn an AAA rating, the highest credit rating.
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 ratio, which tells investors how many years it would take the company to repay its debts, and the debt to total capital ratio, which tells investors how a company is financing its operations.