What is funds from operations?

Funds from operations refers in general to the cash flows generated by operations. The term is most commonly used in relation to the cash flows from real estate investment trusts (REITs).

Funds from operations does not include any financing-related cash flows, such as interest income or expense. It also does not include any gains or losses from the disposition of assets, or any depreciation or amortization of fixed assets.

Thus, the calculation of funds from operations is:

Net income - Interest income + Interest expense + Depreciation
- Gains on asset sales + Losses on asset sales

For example, the ABC REIT reports 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.

A variation on the funds from operations concept is to compare it to the stock price of a company (usually an REIT). This is can be used in place of the price-earnings ratio, which is includes the additional accounting factors just noted.

The funds from operations concept is needed, especially for the analysis of an REIT, because depreciation should not be factored into the results of operations when the underlying assets are appreciating in value, rather than depreciating (which is commonly the case with real estate).

The funds from operations concept is considered to be a better indicator of the operational results of a business than net income, but keep in mind that accounting chicanery can impact a variety of aspects of the financial statements. Thus, it is always better to rely upon a mix of measurements, rather than single measure that can potentially be twisted.

It is possible to adjust the formula even futher for some types of capital expenditures that are recurring in nature; depreciation related to recurring expenditures to maintain a property (such as carpet replacements) should be included in the FFO calculation. This altered format results in lower profitability figures. This revised version is called adjusted funds from operations.

Related Topics

Financial statement analysis 
Incremental cash flow analysis 
What are the limitations of ratio analysis? 
What is free cash flow? 
What is gross profit analysis?