Definition:

Funds From Operations (FFO) is a financial performance metric primarily used by real estate investment trusts (REITs) to measure the cash generated by their operations. It adjusts net income for depreciation and amortization, as well as gains or losses on sales of properties, to provide a clearer picture of the cash flow generated by the core business activities.

Examples

An example of FFO would be a REIT that reports a net income of $1 million, with $200,000 in depreciation and amortization expenses and a $50,000 gain on the sale of a property. The FFO would be calculated by adding back the $200,000 and subtracting the $50,000, resulting in an FFO of $1.15 million.

Formula:

FFO = Net Income + Depreciation & Amortization - Gains on Sales of Properties + Losses on Sales of Properties

How to use the metric:

Investors use FFO to assess the operating performance and cash-generating ability of a REIT. It helps in comparing the financial performance of different REITs by providing a standardized measure that excludes non-cash and non-operational items. FFO is often used to evaluate dividend sustainability and growth potential.

Limitations:

FFO does not account for capital expenditures necessary to maintain or improve properties, which can be significant. It also excludes working capital changes and other cash flow items, potentially overstating the cash available for distribution. Additionally, FFO can be manipulated by the timing of property sales and other accounting practices.

Applies to:

FFO is most applicable to the real estate industry, particularly for REITs, as it provides a more accurate reflection of their operating performance by excluding non-cash items like depreciation.

Doesn't apply to:

FFO is not applicable to industries outside of real estate, such as technology or manufacturing, because these industries do not have the same capital structure or depreciation considerations as REITs. In these sectors, other metrics like EBITDA or net income are more relevant.

Summary:

Funds From Operations is a key metric for evaluating the financial performance of REITs, focusing on cash generated from core operations. While it provides valuable insights into a REIT's ability to generate cash, it has limitations, such as ignoring capital expenditures and potential manipulation. FFO is best suited for the real estate industry and is not applicable to other sectors.