Last Updated on Dec 21, 2022 by Aradhana Gotur
‘Funds from Operations’ (FFO) is an important term in the financial statement of a company. 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 what funds from operations mean in more detail.
Table of Contents
What is FFO?
FFO is the cash flow generated by a company through its business operations. When you reduce expenses from revenues, you get net profit. 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 such non-operational transactions gives you the funds from operations. At this point, it is worthwhile to understand the meaning of business operations.
Business operations mean everything that a business does on a daily basis to keep it up and running.
The formula for calculating FFO
The mathematical formula for calculating the funds from operations is:
FFO = (net income + amortisation expenses + depreciation expenses + losses suffered on the sale of property) – (profits earned from the sale of property + interest income earned on investments)
In the above formula, you will see that 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. You get the actual income earned from business operations by removing such capital expenses and incomes.
Let’s understand this in a bit more detail.
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
Amortisation – 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
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 amortisation costs. It also earned interest of Rs. 7,00,000 on its investment portfolio.
The FFO of the REIT would be = (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 operational efficiency of a company. 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 company during 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 are not factored 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 vs cash flow from operations
When analysing REITs, you would also find the cash flow from operations listed on the REIT cash flow statement. 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. On the other hand, cash flow measures the total gross cash that came in and went out of the business. It includes capital expenses too, and thus, gives a complete picture of the organisation’s finances.
Investing tip: The higher Funds From Operations figure, the better, as it shows higher profitability, which is good for you as an investor.
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.
Frequently Asked Questions
What are funds from operations in the cash flow statement?
Funds from operations is the cash flow generated by a company’s business operations. It is commonly used to evaluate the operating efficiency of a Real Estate Investment Trust (REIT).
Is free cash flow the same as funds from operations?
No. Free cash flow is cash generated from business operations after subtracting capital expenditures.
What is the difference between fund flow and cash flow?
A company’s inflow and outflow of actual cash (and cash equivalents) are called cash flow. On the other hand, the fund flow is the movement of funds flowing in and out of the company.
What is the operating income formula?
Operating income = Net Earnings + Interest Expense + Taxes
What is the cash flow from operations formula?
Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
What is the FFO full form?
FFO stands for Funds From Operations. It is the movement of funds flowing in and out of the company. FFO measures the operational efficiency of a business.
What are adjusted funds from operations?
Adjusted funds from operations are arrived at after adjusting the formula for certain recurring capital expenditures and depreciation on recurring expenditures required to maintain a property. Examples are interior painting and carpet replacements. Such an adjusted figure lowers profitability.