What it means
A company can look healthy on its balance sheet and still be weak if its earnings are small compared with its debts. This ratio tests that by setting annual funds from operations against the full amount of debt.
A higher percentage means the business generates more cash-like earnings for each dollar of debt. Credit analysts like the ratio because it focuses on the ability to repay rather than on accounting profit.
It is especially common for property companies, utilities and other asset-heavy businesses with large, stable debts. Lenders often treat a higher percentage as comfortable and a very low one as stretched, though where the line sits differs by sector.
To calculate it, you use funds from operations from the income statement and cash flow statement, and total debt from the balance sheet. Total debt normally includes bank loans, bonds and lease obligations, and some analysts also adjust for pension deficits.
Different analysts define the elements slightly differently, so the definition should always be stated. The ratio can be read in reverse.
If you divide 100% by the ratio, you get the number of years it would take to repay all the debt from FFO alone, assuming nothing else changes. A ratio of 20%, for example, implies a payback period of five years.
The nuance is that the ratio is a snapshot, and both parts can move. A company can improve the ratio by repaying debt, but it can also appear to improve if FFO is temporarily boosted by a strong year.
Analysts therefore look at the trend over several periods, and many also test what happens to the ratio if rents fall.
In practice
Real-world examples.
Example
A bank is reviewing a loan request from a shopping centre owner with $80 million of debt and FFO of $12 million. The ratio is 12 / 80 = 15%, which is within the lender's comfort range for the sector. The bank agrees the loan but adds a covenant (a promise) to keep the ratio above 12%.
Example
A utility company plans to borrow more to build a new power line. Its finance team calculates how the ratio would fall from 25% to 19% once the new debt is included. The board decides to fund part of the project with new equity to protect its credit rating.
Example
An analyst compares two logistics property companies. One has FFO to debt of 8% and the other 18%. She concludes that the first carries much more financial risk and pays a higher interest rate for it.
Formula
Calculation
FFO to total debt ratio = funds from operations / total debt x 100%
Suppose a property company has funds from operations of $45 million and total debt of $300 million. The ratio = 45 / 300 = 0.15, or 15%. The implied number of years to repay all debt from FFO = 300 / 45 = 6.67 years. If the company repays $30 million of debt and FFO stays the same, total debt becomes $270 million and the ratio rises to 45 / 270 = 16.7%.Case study
Seen in the real world.
Ridgeway Storage Trust is a fictional property company used as an illustrative example. It owned self-storage buildings and had $400 million of debt against annual FFO of $60 million, giving a ratio of 15%.
The trust wanted to buy a competitor for $150 million using borrowed money. The finance director modelled the effect and found that unless the new buildings added $15 million of FFO, the ratio would fall to about 11% and put its credit rating under pressure.
In the illustrative outcome, the trust bought the competitor but funded a third of the price by issuing new shares. The ratio settled near 14%, and the rating agency kept the trust's credit rating unchanged, which also kept the trust's future borrowing costs steady.
Watch out
Common mistakes.
- Using net income instead of funds from operations, which leaves out depreciation add-backs and makes property companies look weaker than they are.
- Comparing the ratio across industries without adjusting for sector norms, when utilities, retailers and property firms carry very different debt levels.
- Ignoring leases or pension deficits in total debt, which understates the real burden.
Questions
People also ask.
What is a good FFO to total debt ratio?
There is no universal number, but ratios above roughly 20% to 30% are often seen as comfortable, and those below about 10% as stretched, depending on the sector.
How is it different from debt to EBITDA?
Debt to EBITDA divides debt by operating earnings, while this ratio divides funds from operations by debt, so the two ratios look at the same question from opposite directions and use different earnings measures.
Can the ratio be improved quickly?
Yes, by repaying debt or selling assets, though a lasting improvement usually needs growth in recurring operating earnings.
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