An FFO-to-debt ratio is a measure of a company's ability to pay its debts using its operating income alone. Funds from operations include money the company collects during the current year from inventory it sells and services it provides to its customers, and this entry is the same in every ratio. Because a company can compare its operating income to different types of debt, several FFO-to-debt ratios are possible.
FFO-to-debt ratios are conservative because they do not include other sources of cash the company can use, such as income from selling equipment or issuing bonds. If an FFO-to-short-term-debt ratio is less than 1, the company has an immediate problem and must sell production equipment or take out another loan. An FFO-to-total-debt (or long-term debt) ratio below 1 may be acceptable if the company expects to increase its sales revenue without increasing its total debt load in future years.
Non-cash expenses are part of the FFO-to-debt ratio, according to Standard & Poor's. Some expenses, such as depreciation on vehicles and production equipment, can be directly linked to operations. A company also can amortize certain costs, such as a fee that it pays for the right to use another company's patent for a period of 10 years. Tax liabilities reduce funds from operations instead of increasing debt.
FFO-to-debt ratios do not include bills for capital projects, according to Fitch Ratings. A capital project is a project a company undertakes to increase the number of products it can manufacture in the future instead of maintaining its current production capacity, so capital project costs do not reduce the company's funds from operations. A free-cash-flow-to-debt ratio, which does include capital costs, will be lower than the comparable FFO-to-debt ratio.
Gross Profit Margin Comparison
FFO is similar to gross profit margin, except it is a cash flow measure instead of a balance sheet measure. Gross profit margin includes all the revenue the company has the right to receive, so it includes non-cash asset accounts such as accounts receivable. FFO includes money a company collects in one year from sales it made in the previous year, but it does not include sales the company make in the current year if the customer will pay the bill the next year.