Know What is Excess Cash Flow

5 mins read
by Angel One


Loan agreements can be fairly verbose and can be hard to comprehend for those who have limited exposure to them. One of the terms you are likely to see in a bond indenture or a loan agreement is ‘excess cash flow’. This article seeks to delve into its meaning and examines the situations wherein it is relevant.

Excess Cash Flow – Definition

The term excess cash flow finds itself mentioned in bond indentures as well as loan agreements and is used to refer to the portion of cash flows of a given company that is required to be paid back to the lender responsible for providing it to the borrower. Ordinarily, excess cash flow is received or generated by a borrower (i.e., company) in the form of revenue or in the form of investments that result in a payment to the lender which is in line with the stipulations laid out in the credit agreement.

Companies that have handed out bond indentures to one or more creditors will find that certain cash flows of theirs will be examined with a fine-toothed comb and restrictions may be in place on the usage of the cash such companies have access to.

Examining the Scope of Excess Cash Flows

Excess cash flows serve as restrictive covenants that provide additional protection against credit risk that lenders and bond investors may otherwise expose themselves to when providing a loan or taking on a bond. In the event that a situation arises that results in excess cash flow as outlined in a credit agreement, the company is required to make a payment to its lender. This payment could amount to a portion of the excess flow which is ordinarily dependent upon the event that resulted in this excess cash flow.

Owing to this very fact lenders lay down restrictions on the manner in which this excess cash can be spent in a bid to control the cash flow of the company in question. However, while doing this the lender must ensure that these restrictions and limitations aren’t too severe such that they limit the company’s financial standing or prevent it from being able to grow. If this were the case, lenders would ultimately end up harming themselves as they’d have a harder time getting their money back from the company.

Excess cash flow is ordinarily determined by lenders keeping in mind a formula comprising of a percentage or amount that exceeds the expected net income or profit over a certain time frame. That being said, this formula varies from one lender to another and is dependent upon the borrower negotiating these terms with their lender.

Events that Trigger Mandatory Payments

In the event that a company is able to raise additional capital via funding measures – take for instance stock issuance – it is likely that they would be required to pay their lender the amount they generated. This amount would not include expenses that arose in a bid to generate this capital. For example, if a company decides to issue additional equity by way of a secondary offering, money raised from this event would result in a payment being needed to be made to the lender.

Further, in the event that a company issued debt via a bond offering, proceeds drawn from this are likely to result in a payment to the lender.

Asset sales are also capable of triggering mandatory payments. This means that if a company has investments or holds shares such as minority interests in alternative companies, and chose to sell these investments for a profit, the company’s lender is likely to require payment for funds drawn from the sale of these assets.

Spin-offs, acquisitions, and windfall income drawn from winning lawsuits are each capable of triggering the excess cash flow clause.

Exceptions to Excess Cash Flow

The sale of certain assets may not be capable of triggering the excess cash flow clause. Included amongst these exceptions is the sale of inventory. This is because companies may need to buy and sell inventory in order to create operating income for their operations. Asset sales made up of inventory, therefore, are likely to be exempt from prepayment obligations.

Capital expenditures may also be exempt from triggering payments. Capital expenditures here include cash used as deposits in a bid to generate new business and cash maintained in a bank that is used to pay for financial products that help limit the risks the company is exposed to.

Formulating Excess Cash Flows

No singular formula exists to calculate what excess cash flows amount to as each credit agreement is likely to have somewhat different requirements that are capable of triggering payments to the lender. In order to estimate what excess cash flow would amount to you must begin by taking into account what a company’s profit or net income is and adding any depreciation or amortization to it. Next, you must deduct the capital expenditures that are required to carry out business operations along with dividends if the company provides any.

Credit agreements are therefore capable of stipulating not only the amount of excess cash flow needed to trigger a payment but also how cash ought to be used or spent.

Concluding Thoughts

Terms that stipulate excess cash flow and payments are ordinarily negotiated between borrowers and lenders.