Excess Cash Flow

Article byKhalid Ahmed
Edited byShreeya Jain
Reviewed byDheeraj Vaidya, CFA, FRM

Excess Cash Flow Definition

Excess cash flow in a loan agreement refers to the part of a company’s cash flow that is required to return to the lender. It helps lenders to invoke a trigger of repayment on the spending of cash by firms so that the firm can promptly repay the loan.

Excess Cash Flow

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Any cash inflows from financing activities, sales assets, and operations trigger the repayment of the loan. Moreover, clause excess cash flow in a loan agreement contains terms like starting events, extra cash flow, exceptions, and percentages assigned on the excess cash for repayment, which are called restrictive covenants. Therefore, this cash flow provision protects the lender’s interests and ensures timely loan repayment.

Key Takeaways

  • Excess cash flow refers to the amount of cash held by a firm that could be used to repay its loans or bond debentures per the terms of its loan agreement.
  • Lenders may use this cash flow as a loan repayment trigger to ensure that the borrower can make timely payments on their loan.
  • The firm retains the amount of cash that remains after deducting all expenses, taking into account working capital requirements and capital expenditure. In contrast, the firm has access to free cash flow, which represents the cash available for maintaining regular operations after paying all expenses.

Excess Cash Flow Explained

Excess cash flow is defined as the amount of cash flow exceeding the trigger level for loan repayment as determined by the lender in the loan agreement. Moreover, excess cash that stimulates loan repayment comes from events like:

Moreover, leveraged finance, corporate lending, and high-yield debt transactions commonly employ this concept. The loan agreement calculates the amount to be repaid to the lender, i.e., excess cash flow sweep or excess cash flow recapture, using the mentioned formula. Here, each lender uses primarily capital collected or an income percentage as a formula in loan covenants, which vary. Thus, the excess cash flow sweep’s purpose is to ensure that the borrower’s surplus cash generated from operations reduces the outstanding debt, mitigating the lender’s risk and expediting the loan repayment.

Besides, the main reason for allowing the borrowing company to retain excess cash flow is to provide flexibility in managing its financial needs and operations. In addition, it is a key tool for lenders in evaluating the creditworthiness of their borrowers and setting up loan conditions, terms, and restrictions. Hence, for proper repayment of a loan using trigger events, lenders:

  • Undertake regular monitoring and reporting of excess cash.
  • Scrutinize borrowers to ascertain their compliance with the loan agreement.
  • Identification of any severe issue potentially jeopardizes the borrower’s repaying capability.

Overall, lenders use this as an effective mechanism of risk management, enhance the probability of repayment of their loan, and give their borrowers the flexibility to elevate their operations, revenue, sales, and business expansion.

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Formula

The formula for calculating excess cash flows sweep involves subtracting the necessary cash outflows from the cash inflows a business generates. One can consider either of the two formulas mentioned below to figure it out.

Excess cash flow = (profit or net income + depreciation and amortization) – (capital expenditures and dividends)

OR

Excess Cash Flow = Total Cash (Revenue) – (Total Current Liabilities – Total Current Non-Cash Assets)

Examples

Let us use a few examples to understand the topic.

Example #1

Let’s say a retail store chain in the US starts the holiday season with a significant discount on its products. As a result, many customers come and purchase from the store, so much so that it generates surplus cash flow. Therefore, such an event triggers the loan repayment to the lender, and a certain percentage of the surplus cash flow gets deposited to the lender as per the agreements, and the left amount gets used for business expansion.

Example #2

Let’s say AMERCO Co. generates $10 million revenue out of its operations in a given year

Also, suppose the total liabilities due of the firm during the year = $7 million

For maintaining its operations, the total current non-cash assets = $2 million

Hence, to calculate the excess cash flow the formula can be used:

Excess Cash Flow = Total Cash (Revenue) – (Total Current Liabilities – Total Current Non-Cash Assets)

= $10 million – ($7 million – $2 million)

= $5 million

Hence, the company has five million dollars as surplus cash that triggers its debt repayment, sponsors its dividend payment to investors, and acquires other businesses.

Excess Cash Flow vs Free Cash Flow

Here are the differences between the two:

ParticularsExcess Cash FlowFree Cash Flow
DefinitionIt is the amount of cash left with a firm after deducting all the expenses in their accounting, like working capital needs and capital investments.Free cash flow means that cash available to the firm is needed for maintaining regular operations after all its expenditures have been met.
PurposeIt aims to help a firm know the amount of cash left to pay its investors or repay its debt as per the loan agreement.Firms utilize it to gauge the amount of cash it has for issuing dividends, reinvestments in their business, acquisitions, or enhancement of operations.
FocusThe focus is making cash available for debt repayment and dividend payments to investors.Here, the focus is more on having enough cash for investment purposes.
FrequencyThey get calculated either as per the schedule in the loan agreement or annually or semiannually.These remain subject to any specific covenants or restrictions the loan agreement outlines.
FlexibilityThese remains subject to any specific covenants or restrictions the loan agreement outlines.In addition, it has flexibility in terms of being subjected to any covenant and remains under the discretion of the management.
SignificanceMoreover, they have significance in debt financing plus credit agreements.Therefore, this is a crucial tool to evaluate a firm’s cash-generating ability and power to invest in future growth.

Frequently Asked Questions (FAQs)

1. Is excess cash flow good or bad?

It could be good or bad, depending on the firms’ handling. If not managed well, then it can:
– Reduce the return on assets
– Elevate the cost of capital
– potentially erode the business value
– lead to the complacency of management
– Finally, it can result in poor decision-making for businesses.

2. What can a company do with excess cash flow?

A company having surplus cash flow can do the following:
– Investment in new projects
– Pay off its debt
– Acquire more unique businesses for expansion
– Issue dividends to return capital to investors
– Or hold on to it to have robust cash reserves for future opportunities or losses.

3. Is excess cash flow always positive?

No, it can be positive or negative. A positive surplus cash flow indicates the company has surplus cash available after meeting all necessary obligations. In contrast, a negative excess cash flow suggests that the company spends more money than it generates.

4. Can excess cash flow fluctuate over time?

Yes, these can vary over time due to changes in a company’s operating performance, capital investment needs, and working capital requirements.

This article has been a guide to Excess Cash Flow and its definition. Here, we explain its formula, examples, and comparison with free cash flow. You may also find some useful articles here –

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