What Are the Funds From Operations to Total Debt Ratio?
The funds from operations (FFO) to total debt ratio is a leverage ratio used by a credit rating agency or an investor to assess the financial risk. The ratio compares earnings from net operating income plus depreciation, amortisation, deferred income taxes, and other non-cash items against long-term debt plus current maturities, commercial paper, and other short-term loans. For this percentage, the costs of existing capital projects are not included in overall debt.
Funds From Operations (FFO) to Total Debt Ratio Formula and Calculation:
The FFO to total debt ratio is determined as follows: Total debt / free cash flow, where: Net operating income + depreciation, amortisation, deferred income taxes, and other non-cash items equals free cash flow.
Total debt consists of long-term debt, current maturities, commercial paper, and short-term loans.
What Does the Funds From Operations (FFO)
to Total Debt Ratio Indicate?
Funds from operations (FFO) measure a real estate investment trust’s cash flow (REIT). The cash comes from its inventory sales and the services it delivers to its clients. GAAP requires REITs to depreciate their investment properties over time using conventional depreciation methods, which might mislead the REIT’s natural performance. This is because many investment properties gain in value over time, rendering depreciation in characterising the worth of a REIT misleading. Depreciation and amortisation must be added back to net income to resolve this problem.
The FFO to total debt ratio assesses a company’s capacity to pay down debt using just net operating income. The smaller the percentage of FFO to total debt, the more indebted the organisation is. A ratio less than one suggests that the firm may need to sell some assets or take out extra debts to stay afloat. The greater the FFO to total debt ratio, the better its position to pay its obligations from operating income, and the lower its credit risk.
Because debt-financed assets typically have valid lifetimes more than a year, the FFO to total debt ratio is not intended to determine whether a company’s yearly FFO fully covers debt, i.e. a ratio of 1, but rather whether it can service debt within a safe timescale. A percentage of 0.4, for example, indicates the potential to service debt completely in 2.5 years. Companies may have resources other than cash from operations to repay debts; for example, they may take out a new loan, sell assets, issue new bonds, or issue new stock.
Standard & Poor’s companies consider a company with an FFO to total debt ratio greater than 0.6 to be at low risk. A company with low risk has a ratio of 0.45 to 0.6; a company with intermediate-risk has a ratio of 0.3 to 45; a company with significant risk has a ratio of 0.20 to 0.30; a company with aggressive risk has a ratio of 0.12 to 0.20, and a company with high risk has an FFO to total debt ratio of less than 0.12. These requirements, however, differ per industry. For example, an industrial (manufacturing, service, or transportation) firm may require an FFO to total debt ratio of 0.80 to obtain a AAA credit rating, the highest credit rating.
Limitations of Using FFO to Total Debt Ratio:
FFO to total debt ratio alone does not give sufficient information to determine a company’s financial status. Other significant leverage ratios for assessing a firm’s financial risk include the debt to EBITDA ratio, which tells investors how long it would take the company to repay its loans, and the obligation to total capital ratio, which shows investors how a company finances its operations.