What is a Cash Sweep?
The Cash Sweep refers to the optional prepayment of debt using excess free cash flows in advance of the originally scheduled repayment date.
Once all mandatory payments have been met, a borrower can opt to pay down a portion of its outstanding debt earlier than anticipated with its excess cash (if any).
Cash Sweep: Financial Model 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.
Modeling the Cash Sweep: LBO Debt Paydown
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 the following have been accounted for:
- “Rolled-Over” Excess Cash on the B/S from the Prior Period
- Cash Flow from Operations in the Current Period
- Cash Flow from Investing in the Current Period
- Cash Flow from Financing in the Current Period
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: Prepayment Pros and Cons
- Credit Profile: 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.
- Financial Stability + Debt Capacity: 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).
- Interest Tax Shield: 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). Thus, the borrower must weigh the pros and 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.
- Prepayment Restrictions: Lenders set different minimum return hurdles based on their risk tolerance among other various factors, so their willingness to permit cash sweeps and the associated fee structures tends to be very specific to each particular situation. The terms of the arrangement surrounding prepayments is outlined in the formal lending agreement between the borrower and the lender (e.g. bank, institutional investor).
- Prepayment Fee: 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.