Funds From Operations (FFO) to Total Debt Ratio: Definition, Calculation, and Industry Insights

The funds from operations (FFO) to total debt ratio serves as a fundamental leverage ratio for evaluating a company’s financial risk, with a specific focus on real estate investment trusts (REITs). In this extensive exploration, we dissect the formula, delve into its applications, and analyze the nuanced impact it has on assessing credit risk and financial health within the finance industry.

The computation of the FFO to total debt ratio involves dividing free cash flow by total debt. Free cash flow encompasses net operating income, depreciation, amortization, deferred income taxes, and other non-cash items. Total debt comprises long-term debt, current maturities, commercial paper, and short-term loans, excluding costs of ongoing capital projects. This meticulous calculation provides a precise measure of a company’s leverage, guiding investors and credit rating agencies in their risk assessment.

Funds from operations (FFO) represents the cash flow generated by REITs, encompassing revenue from inventory sales and services. The inclusion of depreciation and amortization, as mandated by Generally Accepted Accounting Principles (GAAP), addresses the distortion caused by the depreciation of investment properties over time. The FFO to total debt ratio specifically evaluates a company’s capability to service debt using net operating income alone. Unlike a simplistic assessment of annual FFO covering debt fully, this ratio emphasizes the capacity to service debt within a prudent timeframe.

For corporations, an FFO to total debt ratio exceeding 0.6 is considered minimal risk by Standard & Poor’s. However, industry-specific standards play a pivotal role, determining different requirements for an AAA rating based on the sector’s characteristics.

While the FFO to total debt ratio provides a valuable lens into a company’s financial standing, it is not a standalone indicator. To form a comprehensive understanding, additional key leverage ratios such as the debt to EBITDA ratio and the debt to total capital ratio are crucial. These ratios offer a more nuanced evaluation of a company’s financial risk and provide insights into its financing strategies.

The FFO to total debt ratio is inversely related to credit risk. A higher ratio indicates a lower credit risk, signifying the company’s strength in paying off debts from its operating income alone.

The exclusion of current capital project costs ensures that the FFO to total debt ratio focuses on a company’s capacity to service existing debt rather than factoring in potential future debt associated with ongoing projects.

Yes, industry-specific standards play a crucial role in interpreting the FFO to total debt ratio. While Standard & Poor’s deems a ratio over 0.6 as minimal risk for corporations, different industries may have distinct benchmarks for creditworthiness.