What are Funds From Operations? Explained

Funds From Operations (FFO) is used to measure the cash flow from operations and thus is similar to ‘Cash Flow from Operations.’ However, it is generally used in reference to cash flows generated by ‘Real Estate Investment Trust’ (REIT).

Funds From Operations

What are the Funds From Operations?

FFO is a performance indicator created by the National Association of Real Estate Investment Trusts (NAREIT) that is recognized by the SEC to be the standard non-GAAP gauge of financial performance for the real estate sector. Analysts calculate the standard version of FFO by adding amortization and depreciation to net income and subtracting any gains made on the sale of assets.

There are other forms of FFO that the SEC requires real estate companies to report such as the adjusted FFO, company FFO, and others. No matter the type of FFO they use, public companies are required to disclose their FFO on their income statement. Investors can use the FFO to determine the financial performance of a real estate company.

Unlike other accounting methods, the FFO attempts to remove distortion caused by traditional GAAP accounting methods. Using the FFO allows companies to more accurately state their performance.

Explanation- Funds From Operations

A controversial point is that an enterprise making a substantial profit may not have adequate funds at the end of the year/period.

Also, enterprises may have enough funds at their disposal, but they might still have incurred a substantial loss at the end of the year/period.

The reason for this paradox is that the profit and loss account records all expenses paid and outstanding, as well as all income (received and accrued).

Furthermore, charging of depreciation and amortization of intangible and fictitious assets does not require the use of funds in the current period. Rather, they simply reflect the apportionment of past expenses.

This means that the profit and loss account does not distinguish between fund flow and non-fund flow items when calculating the net profit.

Why Funds From Operations is used?

  • For Real estate companies, FFO is used as a performance benchmark as real estate values are proven to fluctuate with macroeconomic conditions, and using the cost accounting examples to compute the financial conditions do not usually serve as an accurate measurement of performance.
  • It includes funds generated from business operations, excluding financing-related cash flows, such as interest income or interest expense. It does not include any depreciation or amortization of fixed assets or gains or losses from the disposition of assets as well.
  • Real Estate Investment Trusts (REITs) is a business that primarily operates on income generated from real estate transactions. Such REIT companies are involved in commercial real estate. It includes selling, leasing, and financing offices and buildings, warehouses, hospitals, shopping centers, hotels, etc. Such companies commonly use FFO.
Explanation- Funds From Operations

Funds From Operations Formula

All the factors used while calculating the Funds from operations can be found in the company’s income statement. These factors include net income, depreciation, amortization, and gains on sales of property and extraordinary items.

FFO Formula = Net Income + Depreciation and Amortization of Real Estate Assets – Gains (losses) on Asset Sale + Losses (Gains) on Restructuring Debt or Extraordinary Items.

Applying Funds From Operations

Funds from operations (FFO) is a primary means of gauging how profitable a REIT’s operations are and can be used in a similar manner to net income or earnings per share (EPS). Instead of viewing valuation on a Price/Earnings basis, REIT stocks are usually viewed on a Price/FFO basis.

The main reason that FFO is better for measuring the performance of a REIT, compared to using net income or EPS, is that it adjusts-out depreciation and amortization expenses. Real estate assets are generally appreciating assets, which means that depreciation expense may not be truly indicative economically. Adding back depreciation usually provides a more clear picture of a REIT’s financial performance.

When evaluating funds from operations, a REIT investor may compare current FFO with the historical FFO numbers for the same company. They may also use FFO in conjunction with other financial metrics, such as debt-to-income ratio to evaluate REITs. REIT investors may also use a variation of FFO called ‘adjusted funds from operations, or AFFO.

Example of Funds from Operations

The ABC REIT reports a net income of $5,000,000, depreciation of $1,500,000, and a gain of $300,000 on the sale of a property. This results in funds from operations of $6,200,000.

Adjusted Funds from Operations

It is possible to adjust the formula even further for some types of capital expenditures that are recurring in nature; depreciation related to recurring expenditures to maintain a property (such as carpet replacements, interior painting, or parking lot resurfacing) should be included in the FFO calculation.

This altered format results in lower profitability figures. This revised version of the concept is called adjusted funds from operations.

FFO vs EBITDA

By ignoring working capital it has similarities to EBITDA – but it’s not exactly EBITDA either – the big difference is that EBITDA attempts to capture profitability from operations, while FFO is levered and captures the effect of taxes and preferred dividends.

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