What is Excess Cash Flow?

600 reads · Last updated: December 5, 2024

Excess cash flow is a term used in loan agreements or bond indentures and refers to the portion of cash flows of a company that are required to be repaid to a lender. Excess cash flow is typically cash received or generated by a company in the form of revenues or investments that triggers a payment to the lender as stipulated in their credit agreement.Since the company has an outstanding loan with one or more creditors, certain cash flows are subject to various earmarks or restrictions for usage by the company.

Definition

Excess cash flow refers to the portion of a company's cash flow that must be repaid to lenders as stipulated in loan agreements or bond covenants. It typically includes cash received or generated by the company through income or investments, triggering payments to lenders as per credit agreements.

Origin

The concept of excess cash flow originated from the complexities of corporate financing and credit agreements, particularly when companies need to manage their debt repayment capabilities. As corporate financing structures diversified, excess cash flow became a mechanism to ensure creditor interests.

Categories and Features

Excess cash flow can be categorized based on its source into operating cash flow, investing cash flow, and financing cash flow. Operating cash flow comes from the company's regular business activities, investing cash flow arises from the purchase or sale of assets, and financing cash flow is related to borrowing and repaying debt. The main feature of excess cash flow is its restricted nature, meaning it must be prioritized for debt repayment.

Case Studies

Case 1: A tech company had a credit agreement requiring it to use 50% of its excess cash flow annually to repay outstanding debt. This provision helped the company maintain a good credit rating during economic downturns. Case 2: A manufacturing firm generated significant excess cash flow by selling non-core assets, which, according to the agreement, was used to prepay high-interest debt, thereby reducing the company's financial costs.

Common Issues

Investors often misunderstand the use of excess cash flow, thinking it can be freely allocated. In reality, excess cash flow is usually subject to strict contractual restrictions and must be prioritized for debt repayment. Additionally, failing to properly manage excess cash flow can lead to default risks.

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