What is Excess Cash Flow?

What is Excess Cash Flow?

Excess cash flow generally reflects the amount of money or cash flow a company generates from operations after it has paid dividends and taken care of essentials like plant and equipment maintenance and other capital expenditures.

Refers to a financial measurement used in the loan agreement which activates the requirement for mandatory prepayments of the loan. Excess cash flow generally reflects the amount of money or cash flow a company generates from operations after it has paid dividends and taken care of essentials like plant and equipment maintenance and other capital expenditures.

If the financial results of the borrower indicate that it has excess cash flow, then the loan agreement typically requires 50% to 75% of that excess cash flow amount to be used as a prepayment of the outstanding loans of the borrower under the loan agreement.

Understanding Excess Cash Flows

Excess cash flows conditions are written into loan agreements or bond indentures as restrictive covenants to provide additional cover for credit risk for lenders or bond investors. If an event occurs that results in excess cash flows as defined in the credit agreement, the company must make a payment to the lender. The payment could be made a percentage of the excess flow, which is usually dependent on what event generated the excess cash flow.

Lenders thus impose restrictions on how excess cash can be spent in an effort to maintain control of the company’s cash flow. But the lender must also be careful that these restrictions and limitations are not so strict that they impede the company’s financial standing or ability to grow, which could end up causing self-inflicted harm to the lender.

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Lenders define what is considered an excess cash flow usually by a formula that consists of a percentage or amount above and beyond expected net income or profit over some time period. However, that formula will vary from lender to lender, and it is up to the borrower to negotiate these terms with the lender.

What is Excluded from Excess Cash Flow?

As mentioned above, the sale of assets can trigger repayments with excess cash flows, but certain assets are excluded. Inventory is one of the examples. Companies buy and sell inventory to generate operating incomes as a resource to support their following daily operations. Hence, inventory sale is usually not included in excess cash flow terms as a trigger of repayments.

Capital expenditures, operating expenses, and expenditures on financing are also exempted from excess cash flows. For example, when a company issues new shares through an investment bank, the capital collected by selling the new shares triggers repayment for its bonds outstanding, but the fees paid to the investment bank is deducted from the excess cash flow.

The costs of expanding business lines and a certain amount of cash held to facilitate the everyday business operation or purchase financial products for risk hedging are also excluded from the excess cash flows repayment.

Exceptions to Excess Cash Flow

Certain asset sales might be excluded from triggering a payment such as the sale of inventory. A company in its normal course of operation might need to buy and sell inventory to generate its operating income. As a result, it’s likely that an asset sale, which comprises of inventory would be exempt from a prepayment obligation.

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Other operating expenses or capital expenditures (CAPEX) might be exempt from triggering a payment such as cash used as deposits to land new business or cash held at a bank that’s used to help pay for a financial product that hedges market risk for the company.

Calculating Excess Cash Flows

There is no set formula for calculating excess cash flows since each credit agreement will tend to have somewhat different requirements that will result in a payment to the lender.

An approximation of a calculation of excess cash flow could begin with taking the company’s profit or net income, adding back depreciation and amortization, and deducting capital expenditures that are necessary to sustain business operations, and dividends, if any.

In other words, a credit agreement might outline an amount of excess cash flow that triggers a payment, but also how cash is used or spent. A lender might allow cash to be used for business operations, possibly dividends, and certain capital expenditures. The terms defining excess cash flow and any payments are typically negotiated between the borrower and the lender.

If excess cash flow is generated, a lender might require a payment that is 100%, 75%, or 50% of the excess cash flow amount.

Example of Excess Cash Flow

Here is a simple example for better understanding. A company holds $1,000,000 bonds outstanding with an interest rate of 5.0% and an indenture that requires repayments of 75% of its excess cash flows.

The company generated a $600,000 EBITDA in a year. The mandatory amortization is $50,000, the cash tax is $100,000, and the capital expenditure is $300,000. The excess cash flow from operation is thus $100,000 (600,000 – 150,000 – [5.0% * 1,000,000] – 300,000).

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In the same year, the company also issued 5,000 new shares at $40/share, and the cost of issuance is $40,000. Thus, the total excess cash flow for this year is $260,000 (100,000 + [5,000 * 40] – 40,000). The payment to bondholders triggered by the excess cash flow should be $195,000 (75% * $260,000).