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Cash Sweep

Understand the Cash Sweep Concept

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Cash Sweep

Cash Sweep Definition in Debt Schedule

The discretionary, early pay-down of debt reduces the principal balance coming due on the date of maturity – which decreases the credit risk of the borrower.

The reduction in debt principal also causes the interest expense (i.e. the periodic payments to the lender in exchange for the borrowing) to decline.

Certain debt providers such as senior lenders (e.g. corporate banks), who prioritize capital preservation above all else, will gladly accept early payment with either minimal (or no) early prepayment penalties imposed on the borrower.

In contrast, other returns-oriented lenders will typically issue debt with provisions prohibiting early prepayment either for a specified period or for the entire duration of the loan. Such lenders may also charge substantial prepayment penalties even should early prepayment be allowed.

Cash Sweep Modeling

In Excel, the formula for the cash sweep must calculate the free cash flow once all required payments are met, including the mandatory amortization of debt.

The excess cash is the amount remaining once all of the following have been accounted for:

If the borrower has remaining excess cash, the borrower can periodically pay down debt early – assuming the credit agreement does not contain language prohibiting such prepayments.

Additionally, the minimum cash balance of the company (i.e. the amount of cash required to be on hand by the company to fund working capital needs) must also be taken into consideration.

Cash Sweep Pros/Cons

One of the key incentives for a company to opt for a cash sweep, other than lowering its interest expense burden, is to positively impact its credit profile – i.e. contributing to a lower debt-to-equity (D/E) ratio.

Early payment improves the company’s financial stability as well as its ability to secure debt financing on a later date when cash is running low (or refinancing in a lower-interest-rate environment).

One drawback, however, is that the reduced interest expense means the “tax shield” benefit of debt financing is also reduced (i.e. the tax savings caused by interest expense lowering taxable income).

Lenders set different minimum return hurdles based on their risk tolerance among other various factors, so their willingness to allow for cash sweeps and the associated fee structures tends to be very specific to each particular situation.

By charging a prepayment penalty, the lender is protecting the yield on their debt and receiving compensation for reinvestment risk (i.e. the risk of finding another borrower), which offsets the interest expense savings of the borrower, As a result, bonds and riskier debt securities lower in the capital structure are costlier forms of debt financing.

A borrower must weigh the pros/cons of using excess cash to pay down debt early, as the benefits of lower interest expense and reduced credit risk must outweigh any prepayment penalties incurred.

Cash Sweep Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Cash Sweep Example Calculation

The first step is to list out the model assumptions for our simple cash sweep exercise.

For purposes of simplicity, the “Excess Cash Available for Cash Sweep” line item is assumed to be $40m in all periods.

In reality, the free cash flow (FCF) amount – i.e. the cash available before optional debt repayments – is impacted by operating metrics such as revenue and EBITDA, as well as financing line items like mandatory amortization.

However, since modeling out an entire income statement and cash flow statement with a debt schedule would detract our attention away from the cash sweep concept, we’ll just extend the $40m FCF assumption for the entire projection.

In our model example, our company has one tranche of debt – Term Loan B, with the borrowing arrangement lasting for 5 years.

Term Loan B – Model Assumptions
  • Beginning Balance (Year 1) = $200 million
  • Mandatory Amortization = 2.0%
  • Cash Sweep = 100.0%

From the first two assumptions, we can calculate the mandatory amortization by multiplying the 2.0% amortization assumption by the original principal amount – which comes out to $4m.

Under a contractual obligation, the borrower must repay 2.0% (or $4mm) of the original principal back to the lender to avoid defaulting.

Next, we’ll be assuming a full cash sweep – i.e. 100% of the excess cash goes towards repaying the principal balance. This is somewhat unrealistic, but we incorporate this into our exercise so that the effects of the cash sweep are more intuitive.

For instance, there is $40m in excess cash in Year 4 with a beginning term loan B balance of $68m.

  • Beginning Term Loan B Balance – Year 4: $68m
  • (–) Mandatory Amortization = $4m
  • (–) Cash Sweep = $40m

In Year 4, the term loan B balance is $64m after deducting the mandatory amortization. The excess cash amounts to $40m – therefore, the cash sweep is also equal to $40m.

The formula for calculating the mandatory amortization can be found below – note the inclusion of the “MIN” function to prevent the ending balance from falling below zero.

Cash Sweep Formula

By the final year of the forecast, Year 5, note that the cash sweep amount is $20m. Since we have the “MIN” function in place to prevent the cash sweep from exceeding the sum of the beginning balance post-mandatory amortization, the cash sweep in Year 5 is $20m and the ending balance is zero.

Cash Sweep Model Output

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