Funds from operations is the cash flows generated by the operations of a business. The term is most commonly used in relation to the cash flows from real estate investment trusts (REITs). This measure is commonly used to judge the operational performance of REITs, especially in regard to investing in them. Funds from operations does not include any financing-related cash flows, such as interest income or interest 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
= Funds from operations
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 can be used in place of the price-earnings ratio, which 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; this is a common situation when dealing with real estate assets.
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 a single measure that can potentially be twisted.
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.