Understanding FFO to Total Debt Ratio: Key Formula and Analysis

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 ability to cover its debt obligations. The ratio compares 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. This ratio is often used to assess financial risk, especially in industries such as real estate investment trusts (REITs).

Calculating the FFO to Total Debt Ratio: Formula and Insights

FFO to total debt is calculated as:

Free cash flow / Total debt

Where: 

• 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. 

Understanding the Implications of the FFO to Total Debt Ratio

Funds from operations (FFO) measures 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. Many investment properties gain value over time, making depreciation an inaccurate reflection of a REIT's worth. Therefore, depreciation and amortization are added back to net income to solve this issue.

The FFO to total debt ratio shows how well a company can pay off its debt using only net operating income. 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. A higher FFO to total debt ratio means a stronger position for a company to pay debts and indicates lower credit risk.

Since debt-financed assets typically last more than a year, FFO to total debt assesses whether the company can service debt over time, not just cover it annually. For instance, a ratio of 0.4 indicates the company can fully service its debt in 2.5 years. Companies may use resources beyond FFO to repay debts, like taking loans, selling assets, or issuing bonds or 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 company might need an FFO to total debt ratio of 0.80 to get an AAA rating, the highest credit rating.

Recognizing the Limitations of the FFO to Total Debt Ratio

FFO to total debt alone isn't enough to determine a company's financial health. Other key leverage ratios include the debt to EBITDA ratio, showing repayment time, and the debt to total capital ratio, indicating how a company finances its operations.

The Bottom Line

The FFO to total debt ratio is a key leverage metric used by investors and credit rating agencies to gauge a company's ability to cover its debt obligations. It compares free cash flow to total debt, where a lower ratio signals higher leverage and risk.

While a ratio above 0.6 often suggests lower risk, standards vary by industry; industrial firms may need higher ratios for top credit ratings. Though useful, it should be assessed alongside metrics like debt-to-EBITDA for a full picture. Understanding this ratio is especially valuable for evaluating REITs and other debt-heavy industries.