What Is Excess Cash Flow?

What Is Excess Cash Flow?

Let me explain excess cash flow directly: it's a key term you'll find in loan agreements or bond indentures, referring to the part of a company's cash flows that must be repaid to lenders. This is typically cash from revenues or investments that, according to the credit agreement, prompts a payment back to the lender.

If your company has an outstanding loan with creditors, certain cash flows come with restrictions on how you can use them. These earmarks ensure the money goes toward debt obligations rather than other purposes.

Key Takeaways

Here's what you need to know: excess cash flow is the cash your company receives or generates that requires repayment to a lender, as outlined in bond debentures or credit agreements. Lenders set restrictions on spending this cash to keep control over debt repayments, but they avoid over-restricting to prevent damaging your company's financial health. If excess cash flow arises, the lender might demand full or partial repayment of that amount.

Understanding Excess Cash Flows

You should understand that excess cash flow conditions are built into loan agreements or bond indentures as restrictive covenants, providing extra protection against credit risk for lenders or bond investors. If something triggers excess cash flow as defined in the agreement, your company must pay the lender, often a percentage based on the triggering event.

Lenders restrict how you spend excess cash to maintain control over your cash flow, but they have to be cautious—these limits shouldn't be so tight that they hinder your company's growth or stability, which could backfire on them. They typically define excess cash flow with a formula, like a percentage above expected net income over a period, though this varies by lender, and it's on you as the borrower to negotiate these terms.

Events Triggering Mandatory Payments

Certain events will force mandatory payments from excess cash flow. For instance, if your company raises capital through stock issuance, you'd likely repay the lender the net amount after expenses. The same applies to issuing debt via bonds—the proceeds could trigger a payment.

Asset sales are another common trigger; if you sell investments or shares in other companies for a profit, the lender might claim those funds. This could also include proceeds from spin-offs, acquisitions, or even windfall income like winning a lawsuit.

Exceptions to Excess Cash Flow

Not everything counts as excess cash flow that requires payment. Sales of inventory, for example, are often exempt because they're part of normal operations to generate income, so you won't face prepayment obligations there.

Other exceptions might include operating expenses or capital expenditures, like deposits for new business or cash held for hedging market risks—these uses of cash typically don't trigger payments.

Calculating Excess Cash Flows

There's no universal formula for excess cash flow since each credit agreement differs, but a rough calculation might start with your company's net income, add back depreciation and amortization, then subtract necessary capital expenditures and dividends.

The agreement will specify what counts as excess and how cash can be used—for operations, dividends, or certain investments. Lenders might require 100%, 75%, or 50% of the excess as payment, and these terms are negotiated between you and the lender.

Excess Cash vs. Free Cash Flows

Don't confuse excess cash flow with free cash flow. Free cash flow is what your company generates from operations after subtracting asset expenditures—it's a measure of efficiency and potential for dividends or buybacks.

Excess cash flow, however, is defined specifically in the credit agreement and might exclude certain expenditures to help your business perform better and ensure debt repayment. Items like taxes or cash for new business are often left out of excess calculations but included in free cash flow.

Conceptual Example of Excess Cash Flow

Take the 2010 credit agreement for Dunkin' Brands, Inc. with Barclays Bank and others for a $1.25 billion term loan and $100 million revolver. The agreement defines excess cash flow in detail under 'Defined Terms' as the excess of consolidated net income plus non-cash charges and working capital adjustments over items like capital expenditures, debt payments, investments, and acquisition costs.

This example shows how precise these definitions get—all capitalized terms are spelled out, and the calculation is the difference between specific summed items, illustrating the detailed nature of excess cash flow in real agreements.

Important Limitations

Remember, excess cash flow has limitations as a performance metric. The 'excess' amount is set by the lender and doesn't reflect your true cash flow, as exclusions are made to boost business performance and secure debt repayment.

A Numerical Example

Consider hypothetical Company A with year-end results: net income of $1,000,000, capital expenditures of $500,000, and interest paid on debt of $100,000. Assuming the agreement allows these expenses, excess cash flow would be $400,000 ($1,000,000 minus $500,000 minus $100,000). If the lender requires 50% repayment, you'd owe $200,000.