Funds from operations built top down and bottom up, adjusted debt with leases, pension and trapped cash, and what a borrower must do to reach a target ratio.
FFO to debt is funds from operations, EBITDA less net cash interest and current tax, divided by adjusted debt. On an illustrative borrower with 40.0 of EBITDA, 14.1 of net cash interest (lease interest included) and 4.2 of current tax, FFO is 21.7; against 188.0 of debt after leases, pension and trapped cash, FFO to debt is 11.5 per cent. Reaching an illustrative 15 per cent target takes 43.3 of debt reduction or 9.3 more EBITDA.
Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Debt to EBITDA measures the debt against earnings before anyone is paid. FFO to debt measures it against what is left after the lenders and the tax authority have been paid in cash, which is the money that could actually go towards repaying principal. Rating agencies use it as a core cash flow leverage ratio, and it moves with interest rates in a way that debt to EBITDA does not. (This is the corporate credit FFO, not the real estate FFO that REIT analysts use.)
| Input | Value |
|---|---|
| EBITDA | 40.0 |
| Depreciation and amortisation | 12.0 |
| Term loan at 8.00%: cash interest | 170.0: 13.60 |
| Interest income on cash | 1.0 |
| Arrangement fees amortised in P&L interest | 0.9 |
| Tax expense, of which deferred | 4.6, 0.4 |
| Lease liabilities (IFRS 16), interest at 6.0% | 25.0: 1.5 |
| Pension deficit | 8.0 |
| Cash, of which trapped or needed for operations | 20.0, 5.0 |
Top down: FFO = EBITDA − net cash interest − current tax = 40.0 − 14.1 − 4.2 = 21.7
Bottom up: FFO = net income + D&A + other non-cash charges + deferred tax = 8.4 + 12.0 + 0.9 + 0.4 = 21.7
Excel: =EBITDA-(CashInterest+LeaseInterest-InterestIncome)-(TaxExpense-DeferredTax)
Net cash interest is the loan's 13.60 plus 1.5 of interest on the lease liabilities, less 1.0 earned on cash: 14.1. Because EBITDA under IFRS 16 is struck before the lease charge, the lease interest has to come out here, or the leases added to debt below would have no matching cost in FFO. Net income is EBIT of 28.0 less P&L interest of 14.50 on the loan and 1.5 on the leases, plus interest income of 1.0, less tax of 4.6: 8.4. Adding back the non-cash items returns the same 21.7. Building it both ways is the check: if the two routes disagree, a non-cash item has been missed or a cash item added back. FFO is before working capital; deduct the 3.5 that working capital absorbed this year and the result, 18.2, is cash flow from operations.
Start with the 170.0 of borrowings, add the 25.0 of lease liabilities and the 8.0 pension deficit, both debt-like claims ranking alongside the lenders, and deduct only the cash that is genuinely available: 20.0 less 5.0 trapped or needed to run the business, 15.0.
Adjusted debt = 170.0 + 25.0 + 8.0 − 15.0 = 188.0
FFO to debt = 21.7 / 188.0 = 11.5% (debt to FFO = 8.66x)
Against the 170.0 of reported borrowings alone the ratio would read 12.8 per cent and leverage 4.25x. The adjustments add 18.0 to debt, 10.6 per cent, and take leverage to 4.70x. The two ratios are tied by one identity:
FFO / debt = (1 − (interest + tax) / EBITDA) / (debt / EBITDA) = (1 − 18.3 / 40.0) / 4.70 = 11.5%
Interest and tax take 18.3 of the 40.0 of EBITDA, so only 54.25 per cent of it converts to FFO. Two borrowers at the same 4.70x leverage will show different FFO to debt if one pays more interest, which is why the ratio matters when rates rise.
Holding adjusted debt at 188.0 and current tax at the same 30.2 per cent of pre-tax profit (the base rate moves the loan, not the lease interest):
| Base rate move | EBITDA unchanged | EBITDA −10% | EBITDA −20% |
|---|---|---|---|
| None | 11.5% | 10.1% | 8.6% |
| +100 bp | 10.9% | 9.4% | 7.9% |
| +200 bp | 10.3% | 8.8% | 7.3% |
| +300 bp | 9.6% | 8.2% | 6.7% |
| Debt / EBITDA | 4.70x | 5.22x | 5.88x |
A 300 basis point rise in rates does to FFO to debt roughly what a 13 per cent fall in EBITDA does, and leaves debt to EBITDA exactly where it was. A credit paper that reports only leverage would show no deterioration at all down the whole of the first column.
Suppose the borrower wants FFO to debt of 15 per cent, an illustrative level; the published rating methodologies map the ratio to bands that depend on business risk, and the current tables should be checked rather than quoted from memory. Two routes:
In practice debt repayment also cuts interest, so the first route needs somewhat less than 43.3; the figure above is the conservative bound.
FFO to debt is 21.7 over 188.0, 11.5 per cent here: EBITDA less what lenders and the tax authority take in cash, against debt that includes the claims ranking beside the lenders. It responds to interest rates, which debt to EBITDA does not. The book walks the same signed number from EBITDA down to cash and sets each EBITDA against the debt it supports; the free workbook for this case carries that walk with every line switchable. For the interest side alone, see how to calculate the interest coverage ratio.
FFO is before working capital movements; cash flow from operations is after them. Here FFO is 21.7 and working capital absorbed 3.5, so CFO is 18.2. Against 188.0 of adjusted debt that is 11.5 per cent FFO to debt and 9.7 per cent CFO to debt. Rating ratios usually use FFO and look at working capital separately.
FFO to debt equals one minus the share of EBITDA taken by cash interest and current tax, divided by debt to EBITDA. With interest and tax taking 45.75 per cent of EBITDA and leverage at 4.70x, that is 54.25 per cent divided by 4.70, or 11.5 per cent. Higher interest lowers FFO to debt at the same leverage.
It is the inverse. Debt to FFO of 8.66x here is 188.0 divided by 21.7, the same information as 11.5 per cent FFO to debt. It reads like a payback period: the years of current FFO needed to repay adjusted debt if nothing else were paid, which is a useful sense check on the multiple.
This article is one calculation from Credit Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: credit, private credit and distressed debt → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.