Controlling the Cash

February 28, 2021
Corporate Finance

If cash is the most important means of transferring value then controlling cash is the priority of any banker/investor. What we need to think about is who needs to get paid first before we do. For example, the suppliers and employees need to get paid to ensure that the company continues to operate and generate cash. From that perspective they need to get paid ahead of investors in the company. This means that employees and suppliers rank above investors in the “cash waterfall” – banking jargon for describing how the cash a company generates  is allocated to those who are looking to receive cash from the company. The legal term for describing the fact that the employees and suppliers must get paid first is “subordination”. Or rather the bank/investor’s claim to get paid is subordinated to the claim of the employees and suppliers.

The aim of a good banker/investor is to ensure that they do not get subordinated to parties who do not deserve to be paid ahead of them. So, how do you decide if another party deserves to be paid in advance? There are in my opinion the following key criteria:

1) If the party not being paid exits or walks away from the company will it be unable to continue generating cash? If the answer to this question is “Yes” then it is in the interests of the banker/investor that the party gets paid before they do.

2) If the party not being paid has a contractual right to get paid in advance which would make it either a breach of contract to not pay that party before the banker/investor.

It is therefore an essential part of the banker/investor’s job to conduct due diligence on the company and understand the following:

1) which parties are essential to the cash generation capability of the company.

2) which parties have a contractual right to get paid ahead of the banker/investor.

After conducting this due diligence and establishing who needs to get paid first the banker/investor can then work out how many parties need to get paid first and how much cash will be left over once these parties have been paid to repay the banker/investor’s own loan/investment. This left over cash is typically reflected in the company’s cash flow statement as “cash flow available for debt service” or “cash flow available for financing”.

The use of terms such as “cash waterfall” and “cash flow” create an image of cash being like water. This is a useful metaphor. Imagine water forming as snow on top of a mountain. This snow melts and turns from a trickle into a river that flows down the mountain. On the way down trees and vegetation absorb some of the water and the rest flows down to the sea. Similarly, cash is generated by sales (or revenue) for a company and then flows down through the company. Some is used to pay suppliers, then employees and finally bankers/investors who reinvest the cash into the capital markets (the equivalent of the river flowing into an ocean).

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