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modern corporate finance

TOPIC A1

THE BASIC CASH MANAGEMENT PROCESS

Every company can be viewed as a cash pool into which funds flow from various sources. Several
techniques are used to speed the collection of such funds. Conversely, cash flows out of the pool for payables
and other disbursement reasons. An important aspect of cash management is to control tightly both cash inflows
and outflows. When cash inflows exceed cash outflows, surplus cash builds up. This surplus can be used to
repay debts or for investment in marketable securities. Alternatively, when outgoing funds exceed the inflow, the
firm must raise money by borrowing or by selling some marketable securities.

THE CONCEPT OF FLOAT

A cash manager's job is to make payments to others as slowly as possible and to convert into cash – or clear
– payments received from others as quickly as possible. The reason is float, the most important element of cash
management. Float is the amount of uncollected funds moving through the financial transfer system. It shows up
as the difference between the balance shown on a firm's checking account and the balance on the bank's books.
For example, suppose a firm writes, on average, $100,000 of checks daily. If it takes four days for checks to
clear and be deducted from the firm's bank balance, the firm's own books will show a cash balance that is
$400,000 less than the bank's records indicate. The firm has the use of these funds, called disbursement float,
as long as this situation persists.

On the other hand, the firm loses the use of check-clearing float – one component of collection float – on
the checks that it has deposited in its account but that have not yet cleared. Suppose the firm deposits $90,000 in
checks every day, and these checks clear in three days on average. The firm's books then show cash balances that
are $270,000 larger than the bank's books indicate. Thus, the firm's net float – the difference between its
$400,000 disbursement float and its $270,000 check-clearing float – is $130,000. This means that the firm's
actual cash balance is $130,000 greater than its recorded cash balance. The firm can invest or otherwise spend
these excess funds. The float on an individual item can be measured in dollar-days and is calculated as the
amount of the check multiplied by the number of days of delay until that check clears:

Float = Dollar Amount times Time Delay

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For example, assume that three checks are collected during the month with the following delays:

Dollar Number of Dollar-Days

Item X =
Amount Days Delayed of Float
1 $1,500,000 X 2 = $3,000,000
2 5,000,000 X 2 = 30,000,000
3 3,500,000 X 6 = 14,000,000
Total $10,000,000 4 $47,000,000

There are $47,000,000 dollar-days of float during the month. The average daily float, based on a 30-day
month, is

Average Daily Float = $47,000,000

30

= $1,566,667

Alternatively, the average daily float can be calculated as the average daily receipts multiplied by the
average delay in collecting each dollar.

The average delay in collecting a dollar equals the total dollar-days of float divided by the total amount
received during the period or

Average Delay = $47,000,000

$10,000,000

= 4.7 days

The average daily receipts can be found by dividing the total receipts by the number of days in the period:
Average Daily Receipts

= $10,000,000
30

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= $333,333/day

The existence of float lies at the core of every system designed to accelerate, decelerate, or control
corporate funds. By reducing collection float, the corporate treasurer can accelerate cash flow and enhance the
return on current assets. Similarly, corporate cash flow may be improved by increasing disbursement float.

The value of decreasing collection float or increasing disbursement float is tied to the opportunity cost of
funds. It can be measured as

Value of Float = Dollar Amount of Float times Time times Interest Rate

For example, suppose a firm can reduce the collection time on $5 million of receivables by three days.
Assuming that it will invest this money at an annual interest rate of 10 percent, it will earn interest at a rate of
.10/365 per day on the $5 million. Therefore, the value of a three-day reduction in collection float is

$5,000,000 times 3 times 0.10/365 = $4,109.59

If collections ordinarily average $5 million daily and the company managed to reduce the float permanently
by three days, it would then be able to free up $15 million in working capital. At 10 percent interest, this
reduction in float is worth $1.5 million ($5,000,000 times 3 times .10) annually. Using a 10 percent discount
rate, the present value of this permanent reduction in float is $15 million ($1,500,000/.10). Reworking this
example with a different interest rate, say 6 percent, reveals that if the company can permanently free up $15
million in working capital, its shareholders will be $15 million richer ($900.000/.6), regardless of the interest
rate. In other words, the value created by a permanent reduction in float is independent of the interest rate.

Collection Float

Collection float is the time that receivables spend in the process of being collected. It consists of the
following four elements:

1. Invoicing float is the interval from the time a company creates an invoice and mails it to the
customer until the customer places the payment in the mail. During this phase of the collection cycle, the
cash manager has no control over the funds.
2. Mail float, the next phase in the cycle, is the time taken by the U.S. Postal Service to deliver the
customer's check.
3. Having received payment, the company experiences processing float, the flow of the check through
the company's accounting system on its way to be deposited.
4. Finally, there is check-clearing float. This is the time it takes to clear each check deposited.

Invoicing float may be reduced only by changing the payment terms. The other three types of float are
controllable. A.2 discusses the various means to accelerate the collection of funds. Exhibit A.1 illustrates the
various types of collection float.

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Exhibit A.1

Disbursement Float

Disbursement float is the time it takes for a corporation's payment to be mailed, received, deposited, and the
funds withdrawn from its bank account. Because funds are available to the firm until its check has actually
cleared through the banking system, it has an incentive to maximize its disbursement float. A.3 describes the
various techniques used to control disbursement.

APPLICATION: VALUING COLLECTION FLOAT

Speedy Eater Company franchises Dine and Dash outlets in several western states. All payments by
franchisees for food and franchise fees are by check, which average around $150,000 a day. At present, the
average delay between the time a check is mailed and the time that funds are available in Speedy Eater's bank
account is five days.

1. What is the average daily float? Dollar-days of float per month?

Solution:

Average Daily Float = $150,000 times 5 = $750,000

Monthly Float = $750,000 times 30 = $22,500,000

2. To reduce this float, Speedy Eater is considering daily pickups of checks from the franchisees. The
cost would be about $100,000 for the necessary cars and drivers. This procedure would reduce the average
delay by two days. If the opportunity cost of funds is currently 12 percent for the company, should it
introduce the daily pickup plan?

Solution:

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With daily pickup, the average daily float can be reduced by $150,000 times 2 = $300,000. The
annual value of this reduction in daily collection float is

$300,000 times 0.12 = $36,000

This is less than the cost of the pickup plan and so is not worth doing.

Instead of mailing checks to its bank, Speedy Eater can use a messenger service. This
procedure would reduce the collection delay by one day and cost $13,000. Should it use the
messenger service?

Solution:

Speedy Eater should use the service because the one-day reduction in collection float would free up
$150,000 in cash. This extra cash is worth $150,000 times .12 = $18,000 annually, which exceeds the cost
of the messenger service. Therefore, the messenger service should be used.

THE FLOW OF MONEY IN COMMERCIAL TRANSACTIONS

Companies use paper or electronic transactions almost exclusively to make payments or to move money
from location to location or from party to party. The exchange of currency, though frequently used by
individuals to purchase goods or services, is not often used in the commercial business environment.
Paper Transactions
Paper transactions are made via a check or draft (unlike a check, a draft must be presented to the payer
before it is paid) and basically serve to transfer value from the payer to the payee (recipient). Paper items are
cleared through the banking system in one of three ways: through the Federal Reserve System (the Fed), through
local clearinghouses, or directly with correspondent banks. Each bank accepting checks for deposit may use one,
two, or all three clearing methods to present checks to the payer's bank.

Local clearinghouse associations across the country facilitate the exchange of checks drawn on local
member banks. For instance, the California Clearing House Association has existed for many years, with
exchange locations in San Francisco and Los Angeles. All major California banks belong; they meet daily to
exchange checks drawn on one another.

The third check-clearing method that banks employ is to present checks to correspondent banks – the
customers are "respondents." The correspondents clear their respondents' checks and may perform other services
as well, such as managing their spare cash, lending them money when necessary, and sending and accepting
electronic funds payments on their behalf.

The goal in moving paper transactions is to collect the money from the payer's bank as quickly as possible
and to optimize the availability of funds to the check's depositor. Aggressive cash management service banks are
constantly reviewing their clearing patterns to achieve the best clearing time (funds availability) at a competitive
cost. Exhibit A.2 follows the flow of checks deposited by Ajax Company in its account at First Trust Bank
through the three methods for check clearing.

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Exhibit A.2

Electronic Transactions
Electronic transactions fall into two broad categories: wire transfers and automated clearinghouse items.
Wire transfers of funds between financial institutions are moved via both public and private networks. The two
most important wire transfer systems are FedWire and the Clearing House Interbank Payment System (CHIPS).

The FedWire system is operated by the Federal Reserve and is used for domestic money transfers. FedWire
allows almost instant movement of balances and also the transfer of government securities between institutions
that have accounts at the Federal Reserve Banks. Other institutions may use FedWire through one of these
account-holding banks, which serve as correspondent institutions. A transfer takes place when an order to pay is
transmitted from an originating office to a Federal Reserve Bank. The account of the paying bank is charged,
and the account of the receiving bank is credited. Most settlements between depository institutions are
conducted over the FedWire network.

CHIPS is a computerized network for the transfer of international dollar payments, linking about 140
depository institutions that have offices or affiliates in New York City. This network was developed by the New
York Clearing House Association to deal with its high volume of international wire traffic.

The New York Fed has established a settlement account for member banks into which debit settlement
payments are sent and from which credit settlement payments are disbursed. Transfers between member banks
are netted out and settled at the close of each business day by sending or receiving FedWire transfers through the
settlement account.

In addition to FedWire, the Fed operates a system of 30 automated regional clearinghouses called the
National Automated Clearing House Association (NACHA). The automated clearinghouses (ACHs) do to
electronic transactions between financial institutions what traditional clearinghouses do to paper checks: sort and
route them to the proper bank, credit union, or savings and loan for payment. The other important distinction
between local check clearinghouses and an automated clearinghouse is that the latter is national in scope and
function. Most ACHs are operated by the Fed under contract with the ACH. The bulk of ACH transactions are
payroll deposits and Social Security payments. Other principal uses include pension, dividend, and interest
payments. Essentially, these electronic transactions substitute computer tapes for paper checks.

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