Excess cash flow is a term commonly found in loan agreements or bond indentures. It refers to the portion of a company’s cash flows that are mandated to be repaid to a lender. This flow of cash is usually in the form of revenues or investments, and triggers a payment as stipulated in the credit agreement.
Since the company has an outstanding loan with one or more creditors, certain cash flows are subject to various earmarks or restrictions on usage by the company.
Key Insights
- Excess cash flow is cash received or generated that necessitates repayment to a lender, following the provisions of a bond indenture or credit agreement.
- Lenders impose restrictions on how excess cash can be spent to maintain control of the company’s debt repayments.
- Restrictions should not harm the company’s financial viability, as this could negatively impact the lender as well.
- If excess cash flow is generated, partial or complete repayment may be required.
Knowing Excess Cash Flows Inside Out
Excess cash flow conditions are embedded within loan agreements or bond indentures as restrictive covenants to provide additional security for lenders or bond investors. If an event occurs that results in excess cash flows as defined in the credit agreement, the company must compensate the lender. Payments might be pegged as a percentage of the excess flow, which usually depends on the event that generated the surplus.
Lenders define excess cash flow typically through formulas, which vary but are generally negotiated by the borrower. The objective is to inhibit expenditures that could jeopardize loan repayments while nonetheless allowing the company to sustain its operations and growth.
Events Triggering Mandatory Payments
Certain events might trigger mandatory payments:
- Capital Raising: If a company raises additional funds through methods like stock issuance, proceeds minus expenses would likely trigger repayment.
- Asset Sales: Income from selling off minority interests or investments could lead to a required payment to the lender.
- Windfalls and Legal Settlements: Gains from spin-offs, acquisitions, or lawsuit winnings may also necessitate recompense.
Exceptions to Excess Cash Flow
Certain assets or expenses may be exempt from triggering repayment obligations. For instance, sales of inventory in the normal ambit operations might not typically activate excess cash flow clauses. Similarly, significant operational or capital expenses essential for sustaining business can often be excluded.
Calculating Excess Cash Flows
Calculating excess cash flow isn’t formulaic as credit agreement conditions differ. However, a general calculation might start with net income, add back depreciation and amortization, and deduct core capital expenditures and dividends. Specific terms defining excess cash flow and requisite repayments are negotiated between borrowers and lenders.
Excess Cash vs. Free Cash Flows
Free cash flow (FCF) represents cash a company generates minus capital expenditures. Unlike FCF, Excess cash flow, as defined in credit agreements, may include specific exclusions. It evaluates remaining cash after necessary operations, hence feeding into strategic measures while giving investors a gauge of financial health.
Real-World Example
Consider Company A:
- Net income: $1,000,000
- Capital expenditures: $500,000
- Interest on debt: $100,000
Excess cash flow: $1,000,000 - $500,000 - $100,000 = $400,000.
Here, if the credit agreement allows for 50% as a repayment mandate, the company pays $200,000 out of $400,000 excess cash to the lender.
Conclusion
Understanding and efficiently managing excess cash flow is crucial for the financial well-being of a company and ensuring adherence to credit agreements, which balances maintaining operations while fulfilling repayment obligations.
Related Terms: cash flow, free cash flow, credit terms, net income.
