What is Excess Cash Flow?

Loan agreements or bond indentures have several clauses and terms. Often, it requires the borrower to be thorough with these terms and negotiate the same with the lender. From laying out the repayment terms to specifying the restrictions on cash flow, an agreement paper is a comprehensive document. While loan agreements may have complex terms and clauses, these are not always difficult to understand. It is also crucial for the borrower to completely understand each term and clause to avoid any misunderstandings and repayment issues. Read on as we guide you through the term excess cash flow.

One of the common terms that can be found in loan agreements or bond indentures is excess cash flow. So, what is excess cash flow as mentioned in these documents? Excess cash flow simply refers to the cash generated by a company through various sources like revenue or investments. This excess cash flow may be restricted by the lender and the borrower may be obliged to pay a certain percentage or complete amount to the lender, as specified in the agreement.

In order to control the borrower's debt repayment, the lender may impose restrictions on the excess cash flow. The lender usually specifies and limits the usage of excess cash flow so as to receive a prepayment on the debt. However, it is equally essential for the lender to not impose strict restrictions as it may hurt the financial ability of a company, thus resulting in the disturbed financial condition of the company. 

Exceptions to Excess Cash Flow

There is no specific set of rules or formulas for calculating excess cash flow. Rather, lenders may specify the conditions of excess cash flow where only specific earnings may be calculated as the excess cash flow. This creates the scope for exceptions to excess cash flow as well.

Certain exceptions to cash flow may be the sale or purchase of inventory. So, here, the revenue generated through the sale of assets may not be calculated as a part of excess cash flow that restricts the borrower from debt prepayment. Usually, companies buy or sell certain inventory in order to maintain their business workflow and so, various lenders do not condition this cash flow under their loan agreement.

Other than this, various other financial holdings by a company, like deposits to buy a new piece of land for business purposes, setting up of a new business, purchase of financial products, etc., may not be a part of the loan repayment agreement. Thus, any excess cash flow generated through or for these purposes may not oblige the borrower for loan prepayment. However, these conditions totally depend on the agreement and negotiation between the lender and the borrower.

How to Calculate Excess Cash Flow?

As discussed above, there is no fixed formula for calculating the excess cash flow. Ordinarily, it may be calculated by taking into account the total profit earned by a company, their net income minus liabilities of a company, their capital expenditures, and depreciation. The leftover amount is what can be termed as excess cash flow. Apart from this, any additional income generated, like those through investments, may also be a part of the excess cash flow.

Depending on the personal agreement and negotiation between the borrower and the lender, the exact condition of excess cash flow is determined. It depends on the lender and the negotiation by the borrower where the lender may permit the usage of excess cash flow for certain business operations. Usually, the lender may specify a certain percentage of the excess cash flow, say 50%, 75%, or 100%, that the borrower must use for debt prepayment if any excess cash flow is generated. These conditions may differ from one lender to another. In some cases, the lender may fix a percentage of the excess cash flow that must be used to prepay the debt amount. 

Events that Trigger Mandatory Payments

Just like specifying exceptions, lenders may also specify certain events that trigger the payment of debts from the excess cash flow. So, as per the specifications of the loan agreement, the lender must oblige to repay the debt if excess cash flow is generated through specified sources. Some of the conditions that may trigger the mandatory debt prepayment are:

• Purchase of new stocks that add up to the company's funding. If a company issues equity to raise money, the raised amount may be specified as the excess cash flow. So, here the lender may impose restrictions on how this amount is used
  

• Sale of assets of a company like holdings or shares that the company has invested in. If the borrower chooses to sell their investments or shares in a different company, it triggers income, and thus, the lender may impose restrictions on this income and specify a certain percentage that has to be used for debt repayment.

Common Mistakes in Handling Excess Cash Flow

Having excess cash flow can indeed be a great financial position, but mishandling it can lead to missed opportunities or financial setbacks. Here are some common mistakes that can be avoided:

• Letting It Sit Idle
  Keeping excess cash in a low-interest savings account means losing potential returns from better investments.
  

• Impulsive Spending
  A sudden influx of money can tempt individuals and businesses to make unnecessary purchases instead of investing wisely.
  

• Ignoring Debt Repayment
  Paying off high-interest debt should be a priority before making speculative investments.
  

• Lack of Diversification
  Placing all excess cash in one asset class, such as stocks or real estate, increases risk exposure.
  

• Neglecting Emergency Funds
  While investing is crucial, maintaining a safety net for unforeseen expenses is equally important.

A strategic approach that includes balancing investments, savings, and debt reduction can ensure that excess cash flow works in your favour.

Conclusion

Terms and conditions that stipulate the debt prepayment through excess cash flow are a matter of negotiation between the lender and the borrower. That's because there is no specific set of rules or formulas for calculating excess cash flow. Lenders may make certain conditions mandatory for loan prepayment while there may be specific exceptions to excess cash flow as well.

Usually, the sale of assets of a company, like investments, holdings, shares, etc., or the issuance of equity or debt through secondary or bond offerings generates excess cash flow subject to mandatory debt prepayment to the lender.

Similarly, the purchase or sale of inventory for business operations, bank deposits for the purchase of business equipment or land, etc., may not be conditioned under excess cash flow. So, negotiation with the lender at the time of agreement is always the right approach to safeguard the usage of excess cash flow.

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