SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 9 – Cash Collection Systems
2
Chapter 9 Agenda
Differentiate between collection system
alternatives, calculate the cost of float,
and understand the underpinnings of lock
box models.
Cash Flow Timeline
3
The cash
conversion
period is the
time between
when cash is
received versus
paid.
The shorter the
cash conversion
period, the
more efficient
the firm’s
working capital.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.
Float
4

When a firm collects receivables (or pays invoices), it is often in the
form of a paper-based check.




Despite advancements in electronic options, many firms still use checks.
However, the check must be (1) received, (2) processed by the
supplier, (3) deposited in their bank, and (4) cleared by the firm’s
bank before the cash is debited from the firm’s account and credited
to the supplier’s.
So long as the check is received by the due date, the firm is in
compliance with the credit terms.
This delay in the receipt and conversion of a check to cash is known
as float.


It’s a delay in the transfer of ‘value.’
Idle balances have an inferred cost.
Types of Float
5

Mail Float

The time it takes the firm to receive the mailed remittance.


Processing Float


Influenced by holidays, weekends, weather, etc.
The time it takes to process and deposit the remittance.
Clearing (Availability) Float

The time it takes to convert the deposit to cash.

The bank assigns an availability time to each check deposited
based on the bank on which the check is drawn (availability
schedule).
Cash Collection Timeline
6
The Importance of Float
7

Eliminating float is impossible, but measuring and
managing it is critical.
Payment & Collection Systems
8

A firm’s perspective on float depends on collections
(collection float) versus disbursements (disbursement float).


A firm is motivated to expedite collections float and slow
disbursement float.
TVM principles can be used to calculate the value of both.
Cash Collection Systems
9


Designing a system to shave hours off one or all of the types of
float might seem trivial.
To show that it is not, assume a firm receives $1 million in remittances
per day which, on average, take 7 days to clear from the date
mailed by the customer.


Given an 10% opportunity cost, the annual cost of float is:


The firm is losing the use of $7 million per day.
$1,000,000 × 7 × 10% = $700,000
If it could reduce float by a third of a day…

$1,000,000 × 6 ⅔ × 10% = $666,667

Saving = $33,333
Cost of Float: Dollar-Day Method
10




This firm has monthly
remittances of $1.8 million, or
about $58,000/day.
Due to collections float, it is
taking, on average, 5.49 days
to collect these funds.
The firm is, on average, losing
the use of $9.6 million/mo. or
$320,000/day.
Assuming this month is
representative of full year’s
operations, the annual cost of
float for this firm where i=8%
is $26,000 (+/-).
Remittances
×
Collection Float
=
Dollar-Day Float
$50,000
×
2
=
$100,000
$1,200,000
×
5
=
$6,000,000
$500,000
×
7
=
$3,500,000
$1,000
×
10
=
$10,000
$1,751,000
$9,610,000
Average Dollar-Day Float = Dollar-Day Float ÷ # Days in Month
= $9,610,000 / 30
$320,333.33
Average Collection Float = Dollar-Day Float ÷ Remittances
= $9,610,000 / $1,751,000
5.49
Annual Cost of Float = Average Dollar-Day Float × Rate
= $320,333.33 × 0.08
$25,626.67
Cost of Float: Dollar-Day Method
11
Remittances


This method
incorporates both the
time lag and the
affected dollar
amounts.
This is NOT measuring
DSO…the A/R has
been received, but is
not yet collected funds
in the firm’s checking
account.
×
Collection Float
=
Dollar-Day Float
$50,000
×
2
=
$100,000
$1,200,000
×
5
=
$6,000,000
$500,000
×
7
=
$3,500,000
$1,000
×
10
=
$10,000
$1,751,000
$9,610,000
Average Dollar-Day Float = Dollar-Day Float ÷ # Days in Month
Idle funds daily throughout the month
= $9,610,000 / 30
$320,333.33
Average Collection Float = Dollar-Day Float ÷ Remittances
= $9,610,000 / $1,751,000
5.49
Annual Cost of Float = Average Dollar-Day Float × Rate
Or, ($1,751,000/30) × 5.49 × 8%
= $320,333.33 × 0.08
$25,626.67
Cash Collection Systems
12




Offering trade credit to customers is the single longest delay
in converting sales to cash.
Another delay is the time it takes to receive remittances once
mailed by the customer.
Customers typically mail paper-based checks timed such
that they are received as close to the credit terms as
possible, but no sooner.
If a firm can expedite the delivery of the mail, remittance
processing, or check clearing, it can improve collection float.
Types of Collection Systems
13

Firms have two, basic options in directing where
customers should remit payments:
 Company
Processing Centers
 Customers
remit payments to the firm’s headquarter site
(centralized) or to a field office (decentralized).
 The
firm processes and deposits its own checks.
 Lockbox
Systems
 Customers
remit payment to a bank lockbox.
Collection System Cost Factors
14

Both types of Collection Systems include fixed and
variable costs, in addition to the cost of collections float:

Where:
N = Number of remittances processed
 F = Average face value of remittances
 D = Number of days for check to clear
 i = Annual opportunity cost
 VC = Variable cost/remittance item
 FC = Fixed cost of managing collection system

Collection System Example
15

A firm has established a Company Processing Center
and is choosing between a centralized and
decentralized collection system.
# of Remittances Processed (N )
Average Face Value of Remittances (F )
i
# of Days for Check to Clear (D )
Variable Cost/ Item (VC )
Fixed Cost (FC )
1,000
$1,500.00
10%
Decentralized Centralized
7
6
$
0.25 $
0.20
$
100.00 $
600.00
Collection System Example
16


A firm has established a Company Processing Center
and is choosing between a centralized and
decentralized collection system:
The decentralized system has the lower cost, and should
be selected.
Treasury Management Services
17


Firms are motivated to improve cash flow to:

Have the cash necessary to perform daily operations.

Increase short-term investment of cash surpluses.

Minimize short-term borrowing in the event of cash deficits.
Banks provide treasury management services to
improve cash flow.

Usually, the ongoing services are paid for with balances.

However, there are frequently upfront costs incurred by the
firm.
Types of Float
18

Earlier collection float was divided into three parts:

Mail


Processing


The time it takes to process and deposit the remittance.
Clearing (Availability)


The time it takes the firm to receive the mailed remittance.
The time it takes to convert the deposit to cash.
Treasury Management Services can improve all three.
Cash Collection Systems
19

Consider this existing procedure for billing customers
through a Company Processing Center:




A return envelope is provided with the invoice.
The remittance address is one of the firm’s many branch offices.
Mail is delivered late morning or early afternoon.
Mail is opened, sorted, processed, and prepared for deposit by
end of day, if possible.


Unreconciled invoices are processed separately.
Remittances are deposited at the local branch of several
different banks the next morning in one of several accounts
maintained nationally leaving cash dispersed across banks;
clearing availability is assigned.
Cash Collection Systems
20

An alternative is to establish a Lockbox System with the bank.





Instead of [one of] the firm’s address[es], the remittance address is a
post office box controlled by the bank with a unique, pre-sorted zip
code (reducing mail float).
Mail is delivered in bulk throughout the day and night, rather than being
bulk sorted at the USPS sorting facility, then fine-sorted at a branch post
office, and delivered once a day by the postman.
Mail is opened and collected by bank employees each hour during the
day and at specific points during the night.
As the mail is opened, it is digitized and transmitted to the firm for
processing (eliminating processing float).
The checks are deposited in the customer’s account throughout the day,
allowing the bank to meet clearing deadlines (reducing clearing float);
availability is assigned.
Cash Collection – Lockbox System
21

Most lockboxes have a fixed cost, plus variable (per item) costs
dependent on volume.






The benefit must outweigh the cost.
Therefore, a lockbox system is most feasible for firms receiving lowvolume, high-dollar remittances.
Not all banks can produce the same results; the clearing times it can
offer are just as important as the cost of its service (lockbox study).
In addition, customer location and associated mail times vary
depending on location (metro, rural, etc.).
For this reason, geographically disbursed firms might maintain
multiple lockbox remittance locations with multiple banks.
An added benefit of a lockbox is elimination of internal fraud.
Lockbox Analysis Example
22

A firm is considering a lockbox system and has sent a RFP to
three banks. Each bank offers different performance levels
and a different cost structure. Mail float has been determined
based on postmark city and date. Processing float is
estimated by the bank. Availability float is based on the
bank’s routing transit number and availability schedule.

Conduct a lockbox study to determine which bank to select and why.
Lockbox Analysis Example
23

The same formula is used for this type of
collection system
Where:






N = Number of remittances processed
F = Average face value of remittances
D = Number of days for check to clear
i = Annual opportunity cost
VC = Variable cost/remittance item
FC = Fixed cost of managing collection system
Lockbox Analysis Example
24
Lockbox Analysis
Bank 1
Monthly Assumptions:
Average Number of Remittances (N )
Average Face Value of Remittances (F )
Total Monthly Remittances
1.2
0.7
1.3
3.2
$
$
i
Total Cost
Bank 3
2,000
2,000
2,000
$
5,000 $
5,000 $
5,000
$ 10,000,000 $ 10,000,000 $ 10,000,000
Mail Float
Processing Float
Availability Float
Total Float (D )
Variable Costs (per item)
Fixed Costs
Bank 2
1.3
0.9
0.9
3.1
1.35 $
500 $
8%
$
10,214
0.95 $
1,000 $
8%
$
1.4
0.4
2.2
4.0
9,695 $
1.27
625
8%
11,932
Select
Bank 2