Cashflow versus profit

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“Turnover is vanity, profit is sanity, but cash is reality,” or more simply, “cash is king.” This is especially true when banks are assessing and monitoring loans. Banks have had plenty of experience in seeing seemingly profitable businesses experience distress or become insolvent through not managing their cashflow properly.
For this reason, a number of financial covenants will be based on cashflow rather than profit. These include the DSCR, LLCR, and sometimes an ICR.
Project finance loans focus almost entirely on cashflow covenants. Leveraged finance transactions usually have a combination of profit and cashflow covenants. Larger corporate transactions rely heavily on profit covenants. SME transactions could be anywhere on the spectrum. But why the difference?

Profitability covenants are usually the easiest to measure, particularly for large businesses. For large businesses, where banks usually have less influency/control over the borrower, converting a standard cashflow statement into cashflow covenants can be a reasonably complex exercise – agreeing which elements of capital expenditure, debt drawdowns and repayments, leases, etc are required or optional, or above or below the CFADS line.
But for smaller businesses, particularly lending to a special purpose vehicle (“SPV”) as is usually done for project and leveraged finance, tracking the cash is a simpler exercise. Given that loans are repaid out of cash and not profits, cash covenants are usually preferred. But where this is more difficult / problematic, profitability covenants are used as a proxy for cashflow. Larger companies are also assumed to have greater ability to raise new equity if needed, boosting cash whenever needed.

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Brendan WalpoleCashflow versus profit

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