FFO to Debt: a Worked Example

A business that generates recurring cash of 20% of its debt each year could, in principle, repay the debt in about five years from that cash alone. It will not, because capital spending, working capital and dividends come first, but the percentage is a clean way of comparing how heavy a company's obligations are against what it produces. A higher percentage means more cash per dollar owed. It is leverage read from the cash side, and as a percentage it moves the other way from a multiple: debt rising against cash pushes FFO to debt down.

S&P Global Ratings names FFO to debt and debt to EBITDA as its two core ratios for corporate issuers. Moody's uses a close equivalent in a number of its sector methodologies, built from operating cash flow before working-capital changes. For larger rated borrowers in New Zealand, Australia and the UK, such as utilities, airports, ports and listed industrials, the ratio is part of how the market prices their debt.

Both halves are the agency's, not the company's. On the debt side S&P adds obligations it regards as debt-like: leases, underfunded defined-benefit pensions net of tax, asset-retirement obligations, deferred purchase consideration, receivables sold to raise cash. It nets accessible cash against debt, though not for every company: where it judges the business too weak, or the owner a financial sponsor, the cash stays out. It may also treat part of a hybrid instrument as equity. On the earnings side, the EBITDA is the agency's adjusted figure, and interest and tax are the amounts actually paid. The result can differ from anything printed in the company's own accounts, which is why a banker uses the agency's published figure rather than rebuilding it from the annual report.

A port operator with a public credit rating, constructed for this page like every figure in it, reports for the year in US$m. Its lease liabilities are already on the balance sheet under IFRS 16, shown outside the borrowings line, and its lease costs are already outside EBITDA.

Now let its floating-rate debt reprice, adding US$12m to cash interest with nothing else changed:

The port earns the same and owes the same, and debt to EBITDA reports no change. FFO to debt has fallen by 1.6 percentage points, because the cash left to reduce debt is smaller. These numbers are the example's; where an agency's thresholds sit depends on how it scores the company's business risk, so neither figure means anything on its own about the rating.

Debt to EBITDA is the bank's own measure and the one most facility covenants test. It ignores the cost of the debt, so two companies with equal multiples and very different interest bills look the same; FFO to debt separates them. Neither ratio is free cash flow. S&P reads that separately, after capital spending and then after dividends, because a company can have strong FFO and still spend all of it on a capital programme. For a lender, the useful habit is to read the agency's ratio, the bank's covenant ratio and a cover ratio together and to ask why they disagree when they do.

The same initials mean something else in property. Listed real estate trusts report a measure called FFO, which in Australia follows the Property Council's guidelines and in the US the REIT industry's definition. It starts from net profit and strips out items such as property revaluations, real estate depreciation or gains on property sales, depending on the definition, and is meant as a measure of underlying earnings for unitholders; the Property Council says plainly that it is not a measure of cash generated. It is not the agency's FFO, and a ratio built on one is not comparable with a ratio built on the other.

DEFINED IN ONE PARAGRAPH → · DEBT-LIKE ITEMS → · LEASE-ADJUSTED LEVERAGE →

For a rated client, the rating is often the covenant that matters. Its treasury policy may commit to a rating level and to the ratios that support it, and its bank facilities may carry a pricing grid tied to the rating rather than to a leverage test. A banker covering the client models the agency's FFO to debt before a large acquisition, a debt-funded capital programme or a special dividend, because the client's own question is whether the deal costs it a notch, and the answer feeds the size and form of the financing: more equity, a hybrid, a slower programme.

For a mid-market borrower without a rating, the ratio is met less often; facilities in the three markets more commonly test debt to EBITDA and a cover ratio. It still has a use. It is a way of asking how fast a business could pay down what it owes from what it generates, after the bills that come first, and a credit analyst can compute it on the bank's own definition of debt when a file needs that reading.

CORPORATE LENDING → · MARGIN RATCHET →