Excess Cash Flow

What Is Excess Cash Flow?

Excess cash flow is the funds retained by a company that may trigger a compulsory debt repayment as specified in the company's bond agreement.

Certain cash flows are subject to various lender-imposed restrictions on how the company can use them when it has amounts outstanding with one or more creditors.

In such situations, the top management may choose to allocate excess cash flow to various uses, including dividend payouts, based on the company's financial strategy and goals.

Some important points to consider are:

• Excess Cash Flow is money that a business receives or generates post-making repayments to lenders per the terms of a bond, debenture, or credit agreement.
• To maintain control over the company's debt repayments, lenders restrict what can be done with the excess cash.
• Lenders impose limitations to control the use of excess cash flow, ensuring it aligns with the terms of the loan agreements or bond indentures.
• Lenders might demand repayments equal to all or a portion of any excess cash flow a business obtains.

Understanding excess cash flows

As restrictive covenants, excess cash flow terms are implemented in bond indentures or loan agreements, so bond investors or lenders have strong protection against default risk. 

Excess Cash Flow is determined after meeting specific financial commitments as outlined in loan agreements or bond indentures, and it serves as a basis for mandatory debt repayment if specified conditions are met.

If excess cash flows occur, the company may be required to use a portion of it to make payments to the lender based on the terms specified in the credit agreement or bond indenture.

Therefore, lenders place restrictions on the additional funds that can be utilized to control the cash flow of the company. 

However, the borrower should also ensure that these limitations and regulations will not suppress the business’s ability to grow financially, which could lead to self-inflicted harm.

Excess cash flow refers to the cash owned by a firm that can initiate an obligatory repayment of debt according to the company’s bond indenture. It is a term typically used in restrictive covenants in loan agreements or bond indentures.

Exceptions to excess cash flows

Excess cash flows can trigger repayments in certain circumstances, but specific assets and expenses are excluded from this process.

For instance, inventory, which is important for generating operating income, is typically exempt from excess cash flow terms due to its essential role in daily operations.

Similarly, capital expenditures (CapEx), operating expenses, and financing expenditures are also exceptions.

When a company issues new shares through an investment bank, the capital received triggers bond repayments, yet fees paid to the investment bank are subtracted from the excess cash flow.

Additionally, other asset sales, especially those involving inventory, might be excluded from prepayment obligations.

Furthermore, operating expenses like cash used as deposits for new ventures and funds held at banks for purchasing financial products to hedge market risks are typically exempt from triggering payments related to excess cash flows.

calculating excess cash flows

There is no general formula for calculating excess cash flow because every credit agreement will normally have different variable parameters that result in a payment to the lender. 

However, it can be determined by deducting capital expenditures (CAPEX) needed to maintain business operations along with dividends from the company’s net earnings or revenue and adding depreciation and amortization to the same.

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

In short, a credit contract can indicate how much cash is used or spent and, at the same time, helps to find the excess cash flow that leads to payment.

This cash can be used to make capital investments, pay dividends to the shareholders, and operate the firms according to a lender if the company holds a large portion of the cash. 

However, in that case, it won’t be able to keep pace with inflation, reducing the purchasing power and limiting the achievement of the company’s future endeavors.

Excess Cash vs. Free Cash Flows

Free Cash Flow (FCF) differs from Excess Cash Flow. FCF is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets (CapEx).

The FCF is an indicator that shows the company's financial flexibility and is also well-liked by the equity, debt, and preferred shareholders, as well as other potential lenders and investors, because it is that portion of cash flow that can be extracted and distributed to creditors and security holders.

Let's take a look at the table below to understand the differences properly:

example of excess cash flow

Let's say Company A ends the year with the following financial results:

• Net income = $800,000
• Capital expenditures for operations = $400,000
• Cash-paid interest on debt = $90,000
• Percentage of excess cash flow for payment = 50%

Suppose that the credit agreement permits both Capex and the interest paid, in which case the business may pay for those costs with cash. However, any money that remains after removing costs from net revenue is considered surplus and must be delivered to the lender.

Excess cash flow = $800,000 - $400,000 - $90,000 = $310,000

Payment due to lender = $310,000 * 50% = $155,000

Let's consider another example with a manufacturing company, XYZ Inc. XYZ Inc., which has issued $2,000,000 in bonds with an annual interest rate of 4.5%. The bond indenture specifies that 80% of the excess cash flows must be used for bond repayments.

In a particular year, XYZ Inc. reported an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of $1,200,000.

The required amortization of the bonds for the year is $80,000, and the company's cash tax obligation amounts to $200,000. Additionally, capital expenditures for the year total $350,000.

Therefore, the excess cash flow from operations is calculated as follows:

1,200,000 - 280,000 - [4.5% * 2,000,000] - 350,000

= 1,200,000 - 280,000 - 90,000 - 350,000 = $480,000

Researched and authored by Jeason Jose | LinkedIn

Reviewed and Edited by Abhijeet Avhale | LinkedIn

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