Excess Cash Flow

Excess cash flow is a concept used in lending agreements or indentures of bonds which applies to the part of a company’s cash flows that must be returned to a lender. That is to say that as a result of its business operations, the excess cash flow is unencumbered money accruing to the company and the company may use it for any defined reason after the normal financial obligations have been fulfilled. Excess cash flow is commonly money obtained or generated by means of an organization in the form of revenues or an investment that triggers a fee to the lender as stipulated in their credit agreement. It is measured via debt holders, whilst shareholders’ focal point greater on free cash flow.

If the company has an unpaid loan from one or more creditors, the company’s use of such cash flows is subject to different assignments or limitations. Any of the company’s financial responsibilities could include the payment of rent for its property, money expended on the procurement of raw materials, employee wages, and the payment of dividends to corporations with shareholder obligations. Debt is a low cost and often used financing approach for companies. Requiring a decrease charge of returns, lenders expect lower dangers and set restrictions on using sure cash flows of the borrowing company.

(Example of Excess Cash Flow)

The provisions for excess cash flows are written into loan agreements or bond indentures as restrictive covenants to provide lenders or bondholders with additional protection for credit risk. In credit agreements or bond indentures, the terms of the excess cash flow, the triggering events, the percentage of repayment to the excess cash flow, and exceptions are specified. The groups are recognized as restrictive covenants, which furnish insurance on savings risks for creditors. The payment could be made as a proportion of the excess flow, which is commonly established on what event generated the excess cash flow.

Overly restrictive terms would limit the growth potential of the company and thus, future profitability. Eventually, it could hurt solvency and instead lead to higher credit risks in the future. Lenders describe what is commonly considered to be a surplus cash flow by a formula consisting of a percentage or amount above and above projected net income or profit over a specified period of time. However, that system will vary from lender to lender, and it is up to the borrower to negotiate these terms with the lender.

For example, if an enterprise is supposed to pay a given percentage of the loan per month, this matrix will be modified by an additional percentage, the exact amount of which will be calculated by measuring all the variables affecting that enterprise in relation to its excess cash flow.

The company would likely be expected to pay the lender the sum generated minus any expenditure that occurred to produce the capital if a company raises additional capital through any financing measure such as a stock issuance. Capital spending, maintenance expenditures, and funding expenditures are also excluded from excess cash flows. For example, when a company issues new shares through a funding bank, the capital accrued by selling the new shares triggers compensation for its bonds outstanding, however, the costs paid to the investment financial institution is deducted from the excess cash flow.

Such sales of assets can be exempt from inducing a tax, such as inventory sales. In various situations, the surplus cash flow figure varies. Certain expenses are not taken into account, depending on contract terms. For a different reason, surplus cash flow is used and serves the interest of credit holders. It is necessary to subtract from the free cash flow the appropriate repayment of the debt, which is partly based on the excess cash flow.


Information Sources:

  1. investopedia.com
  2. wise-geek.com
  3. corporatefinanceinstitute.com