Excess cash flow refers to the cash held by a company that can trigger a mandatory repayment of debt according to the company’s bond indenture. It is a term typically used in the restrictive covenants in loan agreements or bond indentures.
According to the company’s bond indentures or loan agreements, excess cash flow triggers a mandatory repayment of a company’s debt.
The triggering events include cash inflows generated from operating, sales of assets, and financing activities.
Certain transactions are excluded from excess cash flows terms, such as inventory sales, expenses on financing activities, and capital expenditures for expanding new business.
Understanding Excess Cash Flow
Debt is a cheap and commonly used financing method for companies. Requiring a lower rate of returns, lenders expect lower risks and set restrictions on using certain cash flows of the borrowing company. For example, the terms of excess cash flow, the triggering events, the percentage of repayment to the excess cash flow, and the exceptions are specified in loan agreements or bond indentures. These terms are known as restrictive covenants, which provide coverage on credit risks for creditors.
The repayment triggering events are clarified in agreements. Net income exceeding certain amounts, capital gain from the sale of assets, and capital financed through certain funding methods (e.g., issuance of new stocks and bonds) are typical examples.
Once such events occur, excess cash flows are generated, and a portion of them must be used to repay a portion of the outstanding loans. The amount of payment is calculated through formulas determined in loan contracts; usually, a percentage of the income or capital collected.
Although the right to require repayments from excess cash flows lowers credit risks, creditors should carefully determine the appropriate portion of repayments. Overly restrictive terms will limit the company’s growth potential and, thus, future profitability. They might hurt the cash flows and solvency, which will lead to higher credit risks in the future instead.
What is Excluded from Excess Cash Flow?
As mentioned above, the sale of assets can trigger repayments with excess cash flows, but certain assets are excluded. Inventory is one of the examples. Companies buy and sell inventory to generate operating incomes as a resource to support their following daily operations. Hence, inventory sale is usually not included in excess cash flow terms as a trigger of repayments.
Capital expenditures, operating expenses, and expenditures on financing are also exempted from excess cash flows. For example, when a company issues new shares through an investment bank, the capital collected by selling the new shares triggers repayment for its bonds outstanding, but the fees paid to the investment bank is deducted from the excess cash flow.
The costs of expanding business lines and a certain amount of cash held to facilitate the everyday business operation or purchase financial products for risk hedging are also excluded from the excess cash flows repayment.
Example of Excess Cash Flow
Here is a simple example for better understanding. A company holds $1,000,000 bonds outstanding with an interest rate of 5.0% and an indenture that requires repayments of 75% of its excess cash flows.
The company generated a $600,000 EBITDA in a year. The mandatory amortization is $50,000, the cash tax is $100,000, and the capital expenditure is $300,000. The excess cash flow from operation is thus $100,000 (600,000 – 150,000 – [5.0% * 1,000,000] – 300,000).
In the same year, the company also issued 5,000 new shares at $40/share, and the cost of issuance is $40,000. Thus, the total excess cash flow for this year is $260,000 (100,000 + [5,000 * 40] – 40,000). The payment to bondholders triggered by the excess cash flow should be $195,000 (75% * $260,000).
Excess Cash Flow vs. Free Cash Flow
Free cash flow and excess cash flow are two different concepts. Free cash flow refers to the company’s cash left after deducting its cash operating expenses and capital expenditures. Shareholders measure a company’s free cash flow to understand whether the company can make cash distributions after funding its operations and capital expenditures. There is a standardized calculation method for free cash flow.
The calculation of excess cash flow varies in different cases. Depending on contract terms, certain expenditures are not taken into account. Excess cash flow is used for a different purpose and serves the interest of credit holders. The required repayment of the debt, which is partially based on excess cash flow, should be deducted from the free cash flow.
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