Excess Cash Flow

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.

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.

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:

• Sales increase,
• Reduce operation cost plus expenditure,
• Stock issuance,
• Debt issue via bond offers,
• Asset sales,
• Enhanced profitability.

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.

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)

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.