Last Updated on Sep 1, 2021 by Manonmayi

If you go through the financial statements of companies, you would often find the term ‘Funds from Operations’ (FFO), which could be confusing to understand. For those of you who invest in REIT (Real Estate Investment Trust), FFO is an even more common term, and plays an important role in determining the operational efficiency of the investment. In this article, we’ll understand funds from operations in more detail.

This article covers:

FFO: the definition

In simple terms, FFO is the cash flow generated by a company through its business operations. When you reduce expenses from the revenues, you get net profit. However, this profit is derived after considering non-operating incomes and expenses (or incomes and expenses not related to a business’s core activities). For example, for a company selling jewellery, income from investments, or a one time sale of a fixed asset could be considered non operating income.

Removing the effects of these non-operational transactions gives you the funds from operations.

Funds From Operations measure the net inflow of cash and its equivalents due to the operating activities of the business. Click To Tweet

The formula for calculating FFO

The mathematical formula for calculating the funds from operations is: 

FFO = (net income + amortization expenses + depreciation expenses + losses suffered on the sale of property) – (profits earned from the sale of property + interest income earned on investments)

If you see the above formula, the net profit of the business is adjusted with incomes and expenses of capital nature, i.e., those linked to the company’s assets and liabilities. By removing such capital expenses and incomes, you get the actual income earned from business operations.

Let’s understand this in a bit more detail.

Example 1

M/S ABC Limited reported the following financial data:

  • Net profit for the year – Rs 25,65,000
  • Depreciation on fixed assets – Rs 2,75,000
  • Amortization – Rs 1,35,000
  • Gain from the sale of a property – Rs 4,55,000
  • Interest income – Rs 75,000

The FFO for M/S ABC Limited would be calculated as follows:

FFO = (Rs 25,65,000 + Rs 2,75,000 + Rs 1,35,000) – (Rs 4,55,000 + Rs 75,000)
= Rs 24,45,000

Example 2

XYZ REIT reported a net income of Rs 45,25,000. During the year, it wrote off Rs 4,25,000 in depreciation and Rs 2,35,000 in amortization costs. It also earned interest of Rs 7,00,000 on its investment portfolio.

The FFO of the REIT would be calculated as follows:

(Rs 45,25,000 + Rs 4,25,000 + Rs 2,35,000) – Rs 7,00,000
= Rs 44,85,000

Uses of Funds From Operations

As mentioned earlier, FFO is an important metric when studying the financials of a company and assessing the efficiency of a REIT. Here’s how you can use FFO to make your assessment.

When assessing a company

Funds from operations give an actual picture of the cash inflow and the cash outflow in a particular financial year. Thus, it helps you check how efficiently the business uses its resources to generate sufficient funds for operations. Moreover, FFO also enables you to find out the working capital needs of a business and its liquidity position.

When assessing a REIT

In the case of Real Estate Investment Trusts, property values might fluctuate with a change in the country’s macroeconomic trends. On the other hand, the company’s operating profit is calculated using conventional cost accounting methods that don’t factor in these macroeconomic trends.

In such a scenario, the net profit would not portray the true operating picture of the company. In such cases, FFO is considered to be a reliable indicator of operational efficiency. Companies and investors use it as a benchmark against which the efficiency of the REIT is measured. The FFO shows the funds earned by the REIT in a financial year. The higher the amount, the better it is for investors.

Fund flow v/s cash flow from operations

When analyzing REITs, you would also find the cash flow from operations listed on the REIT statement of cash flow. This figure, however, should not be confused with the funds from operations. Fund flow from operations and cash flow from operations are two very different concepts.

FFO measures the net inflow of cash and its equivalents in the business due to the operating activities of the business and does not factor in capital expenditures. Cash flow, on the other hand, measures the total gross cash that came in and went out of the business. It includes capital expenses too and thus, gives a more complete picture of the organization’s finances.

Investing tip: The higher Funds From Operations (FFO) figure the better, as it shows higher profitability. Click To Tweet

As a knowledgeable investor, you should understand the meaning of FFO and how to calculate it. Once you know how to arrive at this figure, you can use it to compare different companies and REITs before you make your investment decision. Remember, a higher figure is better, as it denotes higher profitability, which is good for you as an investor.