Assessing cash flow

Guidance on what you should consider when assessing the cash flow of employers, and non-employers, who have a legal obligation to financially support the scheme.

Published: December 2024

Introduction to cash flow

Paragraphs 18 and 19 of the Employer covenant section of the DB funding code state:

"An assessment of the employer’s current and future cash flow will help trustees determine the following:

1. The level of cash over the employer’s reliability period that could be paid to the scheme, if required, to remedy any deficit from a downside scenario (known as maximum affordable contributions). This should feed into trustees’ decisions around the level of risk that is supportable by the employer covenant when setting the scheme’s journey plan. The journey planning module has more details on this.
2. What deficit repair contributions (if required) are reasonably affordable. The recovery plan module has more details on this.

Trustees’ assessment of the employer’s cash flow should primarily be based on management forecast cash flow information rather than historic cash flow information."

One of the main forms of covenant support from an employer is the cash it generates and is able to pay to the scheme when required. Employer profitability remains an important component of understanding how an employer generates its income, and therefore cash.

Your cash flow assessment should focus on forward-looking forecast information produced by management, using historical information to help you decide on its accuracy and reliability.

Assessing cash flow

Paragraphs 20 to 22 of the Employer covenant section of the DB funding code state:

"An employer’s cash flow means the free cash flow generated by the employer after taking account of reasonable operational and committed finance costs (for example, utility costs, essential maintenance, staff costs, committed debt service costs), but before deficit repair contributions to the scheme or other possible uses of free cash, as set out in the recovery plan section. These include:

• investment in the sustainable growth of the employer
• payments that result in covenant leakage
• discretionary payments to other creditors

The employer’s cash flow should also be considered before contributions made to other DB schemes sponsored by the employer. Although these payments may already be agreed under a schedule of contributions, if cash is not allocated fairly between DB schemes, one scheme might be favoured over another.

Trustees and the employer should work together to make the above adjustments."

As set out in our DB funding code, an employer's free cash flow should be stated before deficit repair contributions (DRCs) or other uses of cash. These are referred to as 'alternative uses of cash' in the 'Recovery plans' section of the code and are as follows

• Investment in sustainable growth of the employer
  

  In general terms, investment in sustainable growth relates to the investment in the business to increase operating cash flows and profitability beyond historical levels. This level of growth should be realistically achieved and maintained without creating a heightened risk of running into difficulty. For example, you would not expect the employer to be financing growth through material debt that would place strain on cash flows, or for the employer to be investing to diversify products where there is likely to be insufficient demand. An example of investing in sustainable growth includes purchasing modern equipment to expand capacity or opening new stores.

  It is important that you differentiate between maintenance capital expenditure and investment in sustainable growth when assessing employer cash flows. This will involve working with the employer and covenant adviser to ensure that capital expenditure is categorised correctly.

  Maintenance capital expenditure relates to reoccurring spending required to sustain historical revenue and profitability (eg capital expenditure spent to repair existing equipment or replace like for like equipment to ensure current manufacturing capacity remains consistent). Reasonable maintenance capital expenditure is deductible ahead of getting to a figure for employer cash flows and is therefore not treated in the same manner as sustainable growth investment.

  A third type of expenditure is where employer growth plans are transformative. These plans facilitate substantial changes in the operations, markets and the financials of the business that could pose a greater risk to the business than investment in sustainable growth. In line with investment in sustainable growth, employer cash flows should be assessed before transformative investment, with the reasonableness of this expenditure considered as part of your affordability assessment for recovery plan purposes. Where transformative investment is material, you should consider the impact of this investment in the same way as you would a transaction.

  Where an employer invests in its wider group, and the investment does not directly improve the employer covenant, this should be considered covenant leakage (see below).

• Covenant leakage
  

  Covenant leakage occurs when available cash (which includes liquid assets) leaves the employer in situations where no clear return of monetary value is due, therefore reducing the ability of the employer to support the scheme in the future. This could take many forms, including the following.

  • Payments to shareholders, including dividend payments and share buybacks. 
  • Intercompany transactions, including payment of non-arm’s length management fees and royalties, inequitable central allocations of group corporate overheads, cash-pooling mechanisms, and intercompany loans that are not expected to be repaid.
  • Excessive executive remuneration and material executive bonuses, relative to competitors and business performance. 
  • Capital expenditure that is not expected to translate into maintaining or improving the existing covenant.
    
    
• Discretionary payments to creditors
  

  Discretionary payments are made when the employer elects to make payments to creditors other than the scheme, at a time when the payments are not due. This could include debt repayments or payment of trade payables ahead of contractual obligations, especially when funded from asset sales.

  Discretionary payments may be balance sheet neutral, however they will likely favour other creditors over the scheme by reducing the cash available to the scheme to cover funding requirements when they are required.

• DRCs to the scheme or other schemes supported by the employer
  

  While DRCs may need to be made to other DB schemes, particularly where these have already been agreed, you should consider assessing the employer cash flows before taking into account these payments. This is to allocate cash equitably between schemes.

The fairness and equitability of the uses of cash set out above should be considered as part of your assessment of reasonable affordability for recovery plan purposes (see the Recovery Plans).

Where a look-through guarantee is in place for the scheme, the guarantor’s cash flows should also be assessed in the same way as for the scheme employer.

Other cash flow considerations

• Proceeds from exceptional disposal of assets: you should not be placing reliance on disposals outside of the ordinary course of business for the purposes of assessing underlying cash flows. Where disposals are material, trustees may need to assess separately whether the disposal has a material impact on the covenant. In doing so, they should consider the use of proceeds and if they are being distributed equitably.

Borrowings

• Contractual borrowing repayments: you should include contractual debt repayments in your assessment of free cash flow and understand the timing and amount of expected payments under a repayment schedule. However, where a repayment of existing borrowings is replaced by new borrowing, both items may need to be netted off for the purposes of calculating free cash flow to show that it is essentially a debt for debt swap. Or, if balance sheet liquid assets are used to repay the capital repayment on maturity it would be reasonable to exclude the repayment from the assessment of free cash flow. Similarly, bullet payments should not be included where these are reasonably certain to be refinanced. See the Prospects section for more detail.
• Increased borrowings: if not used to fund the payment of existing borrowing as outlined above, these should not be factored into your assessment of free cash flow. However, you should understand what the increased borrowings will be used for, and the impact it will have on the covenant (particularly where it results in an increase in gearing and higher future interest costs, and in secured debt ranking ahead of potential scheme claims in an insolvency scenario).
• Equity injections: these could include issuing new shares or capital injections directly from shareholders. In line with increased borrowings, equity injections should be excluded from assessment of free cash flow. However, you should understand what the proceeds will be used for, the impact it will have on covenant, and the scheme risk and equitability.

It may be appropriate for the proceeds from exceptional disposals of assets, debt or equity injections to supplement affordability for recovery plan purposes where these funds are considered liquid or readily recoverable balance sheet assets.

Read Recovery Plans for more information.

Cash flow implications of being part of a wider group

Paragraph 23 of the Employer covenant section of the DB funding code states:

"When reviewing the reasonableness of employer cash flow forecasts, trustees should be mindful of the employer’s position in its wider group, its interactions with other group companies (for example through transfer pricing, intragroup trading and/ or intragroup financing) and the impact this may have on cash flows."

Where an employer is part of a wider group, there are further considerations that need to be assessed when determining the cash flow of the employer.

However, without legally formalised support to the scheme from the wider group (for example, by way of a guarantee or other form of contingent asset support), you should assess covenant support based on the employer, and not take funding and investment risk beyond the level the employer can support.

Transfer pricing and other intercompany trading transactions

Transfer pricing and intercompany transactions could materially affect an employer’s cash flow and may not reflect arm’s-length (ie third party) terms.

An example of transfer pricing is where a group requires an employer to operate under an agreement designed to maximise profits overseas, due to lower taxation. While such an approach may be beneficial to the group, the cash flow of the employer may be suppressed.

You should seek to understand the following.

• The risks and benefits of intercompany mechanisms in place when assessing free cash flow, particularly how these may drive reduced, albeit often more stable, cash flows.
• The level of pension costs, if any, that can be recharged to the wider group through the transfer pricing agreement.
• Any potential risk of changes in agreed terms (eg margins of return and recoup of pension costs) given that you are unlikely to be party to such agreements.

Cash pooling and intercompany financing

Cash pooling is a centralised cash management strategy used by corporate groups to ensure that group financing arrangements are cost effective. This process enables group companies in cash deficit to benefit from the cash surpluses in other group entities. Typically, cash pooling involves a daily cash sweep to/from the treasury company, which is recorded in the accounts as an intercompany balance. This can be done physically (where real cash amounts are swept to/from the treasury company’s bank account), or notionally (where cash is centralised virtually, allowing for real cash to remain locally). While cash pooling is common in corporate groups, it can have an impact on the employer’s ability to support a scheme because of cash assets being removed from, or placed into, the employer’s reach.

Cash pooling has no net impact on the consolidated financial position of the group. However, it will impact the cash position of the employer. For example, highly cash generative employers may have lower levels of balance sheet cash, but higher levels of less liquid intercompany debtor balances.

You should be aware of any cash pooling mechanisms that the employer is party to, and where material ensure you understand the following.

• Intercompany agreements and conditions placed on the employer’s access to the cash pool.
• How it impacts management’s cash flow forecasts.
• The likelihood of cash being available to the pension scheme when required. To help with this you should have knowledge of the balance within the cash pool, and the main expected uses of this facility.

Assessing the appropriateness of management’s forecast cash flow assumptions

Paragraph 24 of the Employer covenant section of the DB funding code states:

"Trustees should consider the appropriateness of management assumptions underpinning the employer’s cash flow forecasts (relative to the risks and opportunities identified when assessing the employer’s market and overall prospects, as discussed below) and the sensitivity of these assumptions to future events, making appropriate adjustments where necessary."

Covenant is inherently forward-looking, meaning reliable management cash flow forecasts play a critical role in understanding the ability of the covenant to support the scheme and its risk now and in the future.

It is reasonable to expect forecasts made available by employer management to typically cover a period between one to three years. Additional sources which can provide forecast information include broker notes, credit rating agency analysis, market consensus forecasts, as well as any forecasts generated by your advisers.

You should form your own opinion of employer forecasts, taking the following into consideration.

• Assessment of the assumptions and variables used to generate forecasts, to understand whether they appear reasonable.
• Review of recent trading performance and prospects.
• Management's previous ability to forecast reliably and accurately. This could be assessed by comparing previous management forecasting to actual results.
• The outlook for the employer’s industry and its competitive position within it.
• The level of volatility or predictability of forecast performance, taking into account the nature of the employer’s operations. Certain industries are highly reliant on volatile raw material costs, or a small number of large contracts. This higher level of volatility should then be considered when assessing forecast cash flow (see Managing year-on-year cash flow variances section below).

Sensitising cash flows

It is common for employers to sensitise management cash flow forecasts. Sensitivities generally include an upside and downside scenario and, particularly in uncertain times, employers may forecast what a severe downside event may look like. Such sensitivities are useful to identify key drivers of risk.

You should be able to review and challenge financial forecasts, and the underlying assumptions, to understand the impact certain scenarios may have on the covenant. You should then consider what impact that could have on the scheme and its risks. You should request access to any cash flow sensitivity analysis the employer, or where applicable, the wider group, may have undertaken for internal or external purposes, for example to meet external reporting obligations. Where employer sensitivity analysis is not available or there are concerns around the appropriateness of the analysis, you may find that it is proportionate to work with your advisers to sensitise forecasts.

You may decide to base your considerations on the sensitised cash flows, depending on the overall conclusion of the robustness of the forecasts provided by management.

When cash flow information is not available

Paragraph 25 of the Employer covenant section of the DB funding code states:

"Where cash flow information is not produced for the employer (or it is not proportionate to produce for covenant assessment purposes), trustees should work with the employer to find a suitable proxy (for example, earnings before interest, tax, depreciation and amortisation (EBITDA), profit before tax or consolidated cash flow), adjusted as necessary to best reflect the employer’s cash flow position."

Not all employers may produce cash flow statements as part of their statutory accounts and forecasting process. While profitability is an indicator of corporate strength and in-year trading, cash flow is typically a more relevant measure of the level of support that can be provided directly to a scheme. Unlike earnings or net income, cash flow excludes non-cash expenses (such as depreciation) and includes spending on fixed assets, as well as changes in working capital.

Where cash flow statements are not prepared at the employer level but are available at a separate reporting level (such as at a consolidating intermediate holding company or group level), you should carefully consider if this is a suitable proxy for the employer’s cash flow. For instance, this may only be appropriate, without adjustments, where the employer(s) account for materially all of the trade and assets owned by the consolidating entity.

Where available cash flow statements cannot be relied upon (for instance, because these include material levels of free cash flow associated with companies that are not scheme employers and/or wider group financing costs), you should work with the employer, and/or scheme advisers, to make appropriate adjustments to determine employer free cash flow. 

Where appropriate adjustments cannot be made or it is not proportionate to produce cash flow information, you may wish to consider alternatives such as adjusted profit before tax or adjusted EBITDA as a proxy. Using proxies increases the risk that actual cash flows may diverge materially. Therefore, we would expect you to factor this into the level of risk you are willing to take based on the employer covenant.

Where there is a high level of covenant reliance in place, it is unlikely to be reasonable to rely on proxies, especially where there are concerns of a material deviation from actual cash flow generation. This could be tested by considering historical performance, if the relevant information is available.

Managing year-on-year cash flow variances

Paragraph 26 of the Employer covenant section of the DB funding codes states:

"Where the employer’s cash flow is cyclical or subject to variance, trustees should consider using an average free cash flow over an appropriate period."

Given the nature of free cash flows, you may observe year-on-year variances or volatility. This may be the case if, for example, an employer uses a large proportion of its cash flows building a new factory in a specific year, or if a short-term lucrative contract is won that results in increased profit and cash inflows that are not expected to recur.

It is important that you understand the nature of such variances and the likelihood of them continuing when assessing future cash flow. In addition, you should assess whether cash flows variances from increased investment today could lead to growth and therefore a strengthening of covenant in future years.  

In some industries, it is normal for cash flows to be variable, and so it may be appropriate to consider a normalised free cash flow figure to smooth the impact of one-off or cyclical occurrences. For example, it may be appropriate to take an average free cash flow figure across three or more years to take account of cyclical volatility. You should consider whether this approach (which is a simplification with limitations) overstates or understates the support available to the scheme from the employer.

This should also be considered when setting your recovery plan. Where cash flows are potentially constrained, it will be important to identify whether there are any points in time where cash flows dip below the level required to support the employer’s continued operations, taking account of any additional sources of available liquidity (eg revolving credit facilities). You should document and justify why the approach taken is reliable and appropriate, and consistent principles should be applied at each assessment.

How to assess cash flows for multi-employer schemes

Where a scheme is sponsored by more than one employer (a multi-employer scheme), you will need to determine how best to assess the cash flows of the combined support.

It may be reasonable to aggregate cash flows based upon the share of liabilities, or number of scheme members associated with each of the employers. It is important to ensure that any intercompany trading cash flows are eliminated when aggregating these figures to ensure that cash is not double counted, and the cash flow support is not over-inflated.

In these scenarios, it is highly likely professional advice will be required.

The examples below outline a number of scenarios for multi-employer schemes and, for each scenario, what could be considered a reasonable approach to assess cash flow. The Identifying employers and assessing their legal obligations to the scheme section of this guidance provides further detail. In each of the examples below, the scheme has two statutory employers.

• Example 1:
  • Membership split: each employer has an obligation to support one half of the membership.
  • Covenant structure: both employers have the same parent, which itself has no other material holdings.
  • Approach: in this instance it is reasonable to consider the consolidated cash flows of the parent company as a proxy for the support available to the scheme.
• Example 2:
  • Membership split: each employer has an obligation to support one half of the membership.
  • Covenant structure: both employers sit within the same corporate group but do not have the same parent company.
  • Scheme is last man standing, and so it is assumed that, in the event of an employer insolvency, the scheme could rely on the remaining employer.
  • Approach: it is reasonable to look at the aggregate cash flows of the two employers – after making adjustments to net off the impact of intercompany trading – to estimate the support available to the scheme.
• Example 3:
  • Membership split: each employer has an obligation to support one half of the membership.
  • Covenant structure: both employers sit within the same corporate group, but do not have the same parent company.
  • Scheme operates on a 'sectionalised' basis (ie scheme assets and liabilities are notionally allocated to employers). Neither employer has any obligations to support liabilities of the other.
  • Approach: in this circumstance it is reasonable to consider the financial strength of each employer relative to its share of the scheme’s funding needs.
• Example 4:
  • Membership split: each employer directly sponsors one half of the membership.
  • Covenant structure: both employers sit within the same corporate group, but do not have the same parent company.
  • Scheme operates on a 'sectionalised' basis (ie scheme assets and liabilities are notionally allocated to employers). However, the trustees receive a legally binding, unlimited guarantee from each employer covering each other’s obligations to the scheme, effectively establishing a joint and several responsibility to the scheme.
  • Approach: in this instance, it is reasonable to consider the aggregate financial strength of the two employers, after making adjustments to net off the impact of intercompany trading.
• Example 5:
  • Membership split: the first employer supports 90% of scheme membership; the second employer sponsors the remaining 10%.
  • Covenant structure: both employers have the same parent, which itself has no other material holdings.
  • Scheme is last man standing.
  • Approach: in this instance, it is reasonable to focus on the financial support that the first employer alone can provide.
• Example 6:
  • Membership split: the first employer supports 90% of scheme membership; the second employer sponsors the remaining 10%.
  • Covenant structure: both employers have the same parent, which itself has no other material holdings. The first employer supporting 90% of membership is weak, with limited ability to stand behind its obligations to the scheme. The second employer is strong enough to support the entire scheme.
  • Scheme is last man standing.
  • Approach: in this instance, there is the potential risk that the second employer exits the scheme by paying its limited share of the section 75 deficit (rather than potentially being liable for the larger employer’s share given the last employer standing nature of the scheme). In this case it would be unreasonable to place reliance on the stronger employer to support the scheme’s risks.
• Example 7:
  • Membership split: the first employer supports 90% of scheme membership; the second employer sponsors the remaining 10%.
  • Covenant structure: As in example 6.
  • Scheme is last man standing, and the trustees receive a legally binding, unlimited guarantee, or legal commitment not to leave the scheme, from the strong employers with limited share of membership.
  • Approach: In this instance, it is reasonable to consider the aggregate financial strength of the two employers.

Considerations for cash flow assessment for particular business models

Considerations for not-for-profit employers

Like 'for profit' entities, charities and other not-for-profit (NFP) entities should normally also prepare cash flow forecasts. Where appropriate, you should consider making adjustments to these forecasts to reflect (and possibly exclude) restricted income.

Restricted funds are money or other balance sheet assets given with a legal stipulation on how they may be used. They may not be available to the scheme, and, if they are not able to be used for their intended purpose, they may need to be returned to funders/donors.

Income statement and balance sheet information in NFP accounts typically split figures into 'restricted' and 'non restricted' items. Additional work is likely to be required with management to understand the impact on cash flow.

You should not automatically assume that restricted income cannot be used to fund the scheme, as this will depend on the scheme’s and NFP’s specific circumstances. You should consider taking legal advice where such restricted funds form a material part of the covenant.

For employers who are registered charities, whilst unrestricted donations and other income may be used for pension contributions, you should recognise management’s need to balance this with using donations for charitable activities. There may be a perception risk to donors for using funds not for charitable activities, ie to pay DRCs.

Given their focus upon charitable purpose, you should also recognise that NFP employers may not target a stable surplus generation year upon year, and that charitable spend is often able to be aligned to the income levels generated in a particular year.

Considerations for regulated industries

Some industries such as financial institutions (including banks, insurance companies and asset managers) and regulated utilities are subject to bespoke regulations and reporting requirements. This may mean management report and forecast cash flow generation in a way that differs to the format and terminology in this guidance. We would still expect the same principles to apply, but you are likely to need to take professional advice when assessing the cash flow support available to the scheme.

Considerations for partnerships and professional businesses

Partnerships (such as Limited Liability Partnerships) typically remunerate partners through profit allocation (commonly using monthly payments on account, eg 'drawings'), and settle partners’ remaining accounts when they retire. These and similar forms of remuneration (eg bonuses) to key personnel in professional businesses (for example law firms, consulting companies and accounting firms) aim to ensure employees are incentivised to improve the profitability and enhance the growth of the business.

The above may result in a large share of cash flow generation being used to fund remuneration expenses. You should consider these dynamics relative to competitors and business performance. In these and similar circumstances, you are likely to need to take professional advice when assessing the cash flow support available to the scheme.

Examples

Example 1: Measuring relevant cash flow for scheme funding considerations from statutory accounting information

Table 1: Accounting cash flow and employer cash flow for funding considerations.

Cash flow statement items	Accounting cash flows (£)	Adjustments (£)	FCF for covenant assessment (£)	Comments
Cash flows from operating activities:
Profit for the period:	3,000,000	-	3,000,000
Adjustments for:
Depreciation of assets	135,000	-	135,000
Impairment of assets	46,000	-	46,000
Income statement, non-cash adjustments	350,000	-	350,000
DRCs	(800,000)	800,000	-	Cash flow for covenant assessment purposes should be before deductions for DRCs
Increase in receivables	(242,000)	-	(242,000)
Increase in payables	85,000	-	85,000
Income taxes paid	(184,000)	-	(184,000)
Interest paid	(237,000)	-	(237,000)
Net cash from operating activities:	2,153,000	-	2,953,000	This should be the starting point of assessing cash flow.
Cash flows from investing activities:
Capital expenditure	(1,225,000)	900,000	(325,000)	After discussing with management, the trustees understand that this balance includes £325,000 of capital for repairing existing machinery. This should then be deducted for the purposes of cash flow as it is maintenance capital expenditure. The rest of the expenditure refers to new production capacity (ie sustainable growth investment), so should not be deducted.
Income on exceptional disposal of assets	1,200,000	(1,200,000)	-	Disposals outside of the ordinary course of business should not be considered for the purposes of assessing cash flows, but trustees should assess separately whether these activities have a material impact on covenant.
Net cash from investing activities:	(25,000)	-	(325,000)
Cash flows from financing activities:
Contractual borrowings repayments	(275,000)	-	(275,000)	Contractual debt repayments should be deducted in reaching cash flow
Increased borrowings	400,000	125,000	275,000	Although increased borrowings should not be included in the trustees' assessment of cash flow, after discussing with management, the trustees understand that this balance includes £275,000 of additional debt to fund debt maturities. This effectively replaces the repayment of existing debt in the above line, and so should be included so that these two-line items effectively net off.
Payments of lease liabilities	(135,000)	-	(135,000)	Lease liabilities are deemed to be part of ongoing trading expenses, and are, therefore, deducted in reaching free cash flow.
Equity injections	-	-	-
Shareholder returns including dividends and share buy-back	(1,000,000)	1,000,000	-	Cash flow for covenant purposes should be before covenant leakage such as shareholder buybacks or dividends.
Net cash from Financing Activities:	(1,010,000)	-	(135,000)
Net increase in cash	1,118,000	-	2,493,000	The example above shows c.£2.5 million of adjusted cash flow, which should be the starting position for the employer's cash flow. This represents a material difference compared with the net cash flow per the accounting cash flow statement (£1.1 million).

The example above shows c.£2.5 million of adjusted cash flow, which should be the starting position for the employer’s cash flow. This represents a material difference compared with the net cash flow per the accounting cash flow statement (£1.1 million).

Example 2: Measuring free cash flow for scheme funding considerations from management accounting information

The employer has forecasted its operating cash generation for the next year to be circa £25.4 million.

Table 2: Management’s operating cash flow expectation for next year

Operating cash flow	£ million
Net income	16.4
Depreciation	5.0
Other non-cash adjustments	7.0
Net working capital changes	-2.0
Deficit recovery contributions	-1.0
Expected operating cash flow	25.4

Management informed the trustees that the planned allocation of this cash generation is as follows:

• £8.5 million to capital expenditures, of which £3 to £4 million (approximately) will be invested in new machines to improve production efficiency and capacity, and the rest to maintain the current equipment.
• £4.5 million to debt repayments, of which £2 million will be an early repayment of future instalments, and the rest in line with contractual obligations.
• £4 million to intercompany positions:
  • £2 million as a loan to a new subsidiary outside of the covenant structure
  • £2 million as a deposit in the group's cash pool balance
• £3.9 million to dividends to the parent company (outside of the covenant structure):
  • £2.4 million as ordinary dividend
  • £1.5 million as special dividend for restructuring intercompany positions
• £1.5 million allocated as a special, exit bonus to the Chief Executive Officer who is stepping down after a decade working for the employer.

The above intended uses result in management’s net cash flow being calculated as £3 million.

Trustee cash flow assessment for covenant purposes

The employer cash flow relevant for scheme funding purposes is the employer’s free cash flows after maintenance capital expenditures and external (debt) obligations, but before sustainable growth capital expenditures, payments resulting in covenant leakage, discretionary payments to other creditors, and DRCs.

Given the information provided above, the trustees make the following assessment of free cash flow:

• Operating cash generation: £25.4 million – this is the starting point for assessing the cash flow for covenant purposes.
• Expenditures to deduct for the purposes of assessing cash flow.
  • Maintenance capital expenditures – out of the £8.5 million allocated to capital expenditures, approximately £3 to £4 million is for sustainable growth capex (new machines). This means the maintenance capex is approximately (£8.5 million - £3 to 4 million) = £5.5 to £4.5 million (midpoint being £5 million).
  • Scheduled debt repayment – out of the £4.5 million in debt repayments, £2 million are early repayments. This means that scheduled, contractual repayments are (£4.5 million - £2 million) = £2.5 million.
• Expenditures to be excluded:
  • Sustainable growth capex (new machines): £3 to £4 million.
  • Early debt repayment: £2 million.
  • Intercompany loans / deposits: £4 million.
  • Dividends: £3.9 million.
  • Special bonus to senior management: £1.5 million.
  • DRCs: £1 million.

The trustees then estimate the employer’s free cash flow available for funding purposes and alternative uses of cash to be between £18.4 and £19.4 million. This is materially different to the net cash flow outline above as per management’s intended uses of cash.

Table 3: Estimated free cash flow for funding purposes

Estimated free cash flow	Value (£ million)
Expected operating cash flows	25.4
Adding back DRCs	1.0
Maintenance capital expenditures (midpoint considered reasonable given the relatively tight range provided by management)	-5.0
Contractual borrowings repayments	-2.5
Estimated free cash flow	18.9

Example 3: Sensitising cash flows

Operating cash flows have declined by approximately 8% over the past couple of years, reaching £377.1 million. However, management expects a significant rebound, projecting almost a 40% increase to £523.4 million over the next three years. This forecasted growth comes against a backdrop of anticipated inflation at around 3% annually during the same period.

Table 4: Management cash flow

Management operating cash flows	1 actual (£ million)	2 actual (£ million)	3 actual (£ million)	4 forecasts (£ million)	5 forecasts (£ million)	6 forecasts (£ million)
Profit from product A	207.1	171.5	158.2	142.4	170.9	179.4
Profit from product B	81.3	65.4	66.8	73.5	139.6	265.3
Profit from product C	122.4	130.9	126.6	130.4	134.3	138.8
Total profit	410.8	367.8	351.6	339.9	439.5	572.4
Depreciation	20.0	21.0	20.5	20.5	20.5	20.5
Interest expenses	-5.0	-4.0	-5.0	-4.5	-4.5	-4.5
Net working capital changes	-15	20	10	5.0	-50.0	-65.0
Operating cash flows	410.8	404.8	377.1	367.3	410.8	534.0

Management explained to the trustees that this expected growth is driven by the following:

• A nearly 300% increase in Product B over the forecast period, driven by an expected increase in demand for this product within the UK market. This is despite the product's weak performance over the past three years.
• Moderate, but positive growth in Product A (a product experiencing structural decline in demand), primarily due to the employer's expectation of gaining market share as competitors exit the segment.
• Product C growing at a rate consistent with inflation, given the stable demand and multi-year contracts already in place for this item from different geographies and industries.

After thoroughly discussing these projections with management, the trustees find the forecasts to be ambitious. As a result, they decide to adjust the cash flow projections with the following assumptions:

• Product B to grow at twice the rate of inflation to reflect this is expected to be a growth engine for the employer, but at a more prudent basis than expected by management, and to essentially recover the performance already achieved recently before a period of weakness.
• Product A to continue to decline in line with its previous performance, given the declining market and lack of official communications from competitors regarding their intentions towards the sector.
• Product C to grow in line with inflation and management expectations.

Table 5: Sensitised cash flow

Sensitised operating cash flows	1 actual (£ million)	2 actual (£ million)	3 actual (£ million)	4 forecasts (£ million)	5 forecasts (£ million)	6 forecasts (£ million)
Profit from product A	207.1	171.5	158.2	138.5	121.2	106.1
Profit from product B	81.3	65.4	66.8	70.8	75.1	79.6
Profit from product C	122.4	130.9	126.6	130.4	134.3	138.3
Sensitised profit	410.8	367.8	351.6	339.7	330.6	324.0
Depreciation	20.0	21.0	20.5	20.5	20.5	20.5
Interest expenses	-5.0	-4.0	-5.0	-4.5	-4.5	-4.5
Net working capital changes	-15	20	10	-5.0	-5.0	0.0
Sensitised operating cash flows	410.8	404.8	377.1	360.7	351.6	340.0

Example 4: Adjusting EBITDA to estimate cash flows and normalising cash flows

Management does not produce specific cash flow information for the employer, and it is unclear how the employer contributes to the overall cash flow of its closest parent company (which is outside the covenant structure), where consolidated cash flow data is available.

However, the trustees still need to understand the employer’s cash generation capacity for their covenant assessment.

After discussions and further analysis, given the circumstances of the scheme (well-funded and with relatively limited covenant reliance), management and the trustees agree that estimating cash flows using EBITDA, along with several income statement and balance sheet adjustments, is a sensible approach.

Upon reviewing the available information, management and the trustees identify several key items that significantly impact the employer's cash flow but are not included in EBITDA: interest and tax expenses, net working capital movements and capital expenditures, finance leases, debt repayments, and certain litigation outcomes.

These factors materially affect EBITDA, causing cash flow estimates to vary, with an average of £15.7 million over the period considered (average EBITDA is £32.7 million during the same timeframe).

Table 6: Adjusted EBITDA as proxy for cash flow

Adjusted EBITDA	1 (£ million)	2 (£ million)	3 (£ million)
EBITDA	33.0	32.1	33.1
Interest expenses	-1.1	-1.1	-1.2
Tax expenses	-3.5	-3.3	-3.5
Net working capital changes	-2.0	-1.4	-0.5
Capital expenditures	-4.9	-5.4	-5.4
Finance leases payments	-5.0	-5.0	-5.0
Debt repayments	0.0	-18.0	0.0
Proceeds / outflows from legal disputes	25.0	-10.0	0.0
Adjusted EBITDA as proxy for estimated cash flow	41.5	-12.1	17.6

After careful consideration, management and the trustees agree to exclude the impact of litigation outcomes from the calculations when estimating the employer's underlying cash generation capacity. This adjustment results in a lower average cash flow estimate of £10.7 million.

Adjusted EBITDA as proxy for cash flow - £ million	1	2	3
Adjusted EBITDA as proxy for estimated cash flow	41.5	-12.1	17.6
Adjustment for one off, extraordinary movements	-25.0	10.0	0.0
Normalised adjusted EBITDA as a proxy for estimated cash flow	16.5	-2.1	17.6

Please note that the above considerations around using adjusted EBITDA as a proxy for cash flow might be appropriate in circumstances where the scheme is well funded and has a relatively low covenant reliance. Under different circumstances and where there are concerns that actual cash flow generation might be materially different from proxies, it might be more appropriate to produce cash flow information.

We may revise the covenant guidance when needed and include industry feedback. Send comments or queries about the new guidance to covenantguidance@tpr.gov.uk.

Back to top

Is this page useful?