Basic Cash Management Process Essay

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: 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 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.