LOS 2
Managing Cash Inflows and
Outflows
Learning Outcome Statement (LOS)
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define cash management
understand why it is advantageous for firms to hold
cash and similar assets
identify different money market instruments
understand lockbox system and discuss some
warnings about lockbox location decisions
discuss various cash concentration strategies
discuss various disbursement management strategies
What is Cash?
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Cash is a very fluid substance. It knows no language barriers. It
changes from taka to pounds to dollars, and then into other
forms.
Cash is king, because
 Cash payout is the best measure of a business's success.
 Cash is the life blood of a corporation.
 Cash appreciation is necessary for proper planning and
decision making.
Managed well, your company remains healthy and strong.
Managed poorly, your company goes into cardiac arrest.
Cash Management
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Cash management refers to the management of cash from the time
it starts its transit to the firm until it leaves the firm in payments.
Cash management encompasses the design of collection and
disbursement systems for cash and the temporary investment of
cash while it resides with the firm.
If you haven't considered cash management an important issue,
then you're probably undermining your business's short-term
stability and its long-term survival.
Cash Management
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The cash management function is a general designation for two
distinct corporate activities: cash flow acceleration and
liquidity account allocation.
The former problem concerns procedures for speeding cash
collections from customers and slowing cash disbursements to
suppliers so as to optimize the firm's use of cash.
The latter problem, on the other hand, takes the firm's cash
flow as given and determines the minimum cash balance, the
excess to be held in the form of marketable securities.
Importance of Cash Management
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Some observations from Business Week (April 28, 2003):
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… cash flow is a better way to value companies … Earnings are
an accounting fiction … more cash equals more value …
Everything … including how much investors are willing to pay for
a stock … ties back to expectations about cash …
Standard & Poor's added liquidity analytics to its ratings in 2002;
many companies have had their debt downgraded, primarily due
to cash concerns.
… money is tied up when customers don't pay their invoices,
suppliers are paid too quickly or not fast enough, and inventories
sit unsold …
Corporate America has more than $620 billion – 35% of total
sales – blocked by inefficient cash flow management.
Why Hold Cash and Marketable
Securities?
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The finance profession recognizes the three primary reasons offered by economist
John Maynard Keynes to explain why firms hold cash.
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Speculation – creating the ability for a firm to take advantage of special
opportunities. Example: purchasing extra inventory at a discount that is greater
than the inventory carrying costs.
Precaution – holding cash as a precaution serves as an emergency fund for a
firm. If expected cash inflows are not received as expected cash held on a
precautionary basis could be used to satisfy short-term obligations that the cash
inflow may have been bench marked for. Because cash management services.
Because cash inflows and cash outflows are somewhat unpredictable, firms
generally hold some cash reserves for random, unforeseen fluctuations in cash
flows.
These safety stocks are called precautionary balances- the less predictable the
firm's cash flows, the larger such balance should be. However, if the firm has easy
access to borrowed funds-that is, if it can borrow on short notice (for example, via
line of credit at the bank)- its need for precautionary balance is reduced.
Why Hold Cash and
Marketable Securities?
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Transaction – firms hold cash in order to satisfy the cash inflow
and cash outflow needs that they have.
Compensating Balance: It is the minimum checking account
balance that a firm must maintain with a bank to help offset the
costs of services such as check clearing and cash management
advice.
The size of the minimum cash balance
depends on:
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How quickly and cheaply a organization can raise cash when
needed?
How accurately managers can predict cash requirements?
 (Cash Budget helpful)
How much precautionary cash the managers need for
emergencies?
The organization’s maximum cash
balance depends on:
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Available (short-term) investment opportunities.
 e.g. money market funds, CDs, commercial paper
Expected return on investment opportunities.
 e.g. If expected returns are high, organizations should be
quick to invest excess cash
Transaction cost of withdrawing cash and making an
investment.
Demand for cash for daily transactions
 (Cash Budget helpful)
The Money Market
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It is important for the student of working capital management to
be familiar with the basic instruments of the money market that
are used by many firms as investment alternatives to cash and
larger firms as financing vehicles.
While all the instruments are traded in this market are quite safe
relative to other investments (such as common stocks), they
differ somewhat in risk and return.
Some of the popular money market instruments are Treasury
bills, commercial paper, certificate of deposits, bankers’
acceptance, repurchase agreements, and eurodollars.
Money Market Instruments
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Treasury bills – government-backed securities issued on a
discount basis in minimum denomination of $10,000. Maturities
range from 3 months to 1 year.
Commercial paper – a short-term unsecured promissory note
issued in the open market and represents the obligation of the
issuing corporation, and rates are determined in part by the
creditworthiness of the corporation. Typically, commercial paper
is issued as a zero-coupon instrument, with a maturity of 50
days or less, but not more than 270 days.
Certificate of deposits – a financial asset with maturity from a
few weeks to several years issued by a bank or thrift that
indicates a specified sum of money has been deposited at the
issuing depository institutions.
Money Market Instruments
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Bankers’ acceptance – a promissory note issued by a business
debtor, with a stated maturity date, arising out of a business
transaction. Called bankers’ acceptance because a bank accepts
the ultimate responsibility to repay the loan to its holder by
endorsing the note, in return for a fee.
Repurchase agreements – the sale of a security with a
commitment by the seller (usually government securities dealers)
to buy the security back from the purchaser at a specified price
at a designated future date. Basically, a RP is a collateralized
loan, where the collateral is a security.
Eurodollars – U.S. dollar-denominated deposits at foreign
banks or foreign branches of American banks. By locating
outside of the United States, eurodollars escape regulation by
the Federal Reserve Board.
Flotation and Check Clearing
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Float is the term for the dollar amount of checks that a firm
could cash were they not in the mail.
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Float is basically the difference between bank cash and book
cash.
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Positive (disbursement) float: bank balance > book
balance (e.g. writing a cheque reduces book cash before bank
cash)
Negative (collection) float: bank balance < book balance
(e.g. receiving and depositing a cheque increases book cash
before bank cash)
Must keep track of float to know true cash on hand.
Flotation and Check Clearing
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Float management involves minimizing collection float and
maximizing disbursement float.
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Electronic Data Interchange (EDI) may make traditional float
management obsolete in the future.
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Collection float is composed of:
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Mail float (time cheques are in the postal system)
Processing float (time taken for receiver of cheque to
deposit it to the bank)
Clearing float (time taken for banking system to clear the
cheque)
Flotation and Check Clearing
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Total Transit Time: Mail Float+ At-Firm Float+ Clearing Float.
Opportunity cost of Float :
Float Type
Mail Float
At-Firm Float
Clearing Float
Total Transit time
Float time
(Days)
4.0
0.5
1.3
5.8
Receipts
(per day)
Taka 2 mil.
Taka 2 mil,
Taka 2 mil.
Total Float
Float in Taka
Taka 8.0 mil.
Taka 1.0 mil.
Taka 2.6 mil.
Taka 11.6 mil.
Required Return 10%
Opportunity cost of float Taka 1.16
(=Taka11.6 x 10%) mil. Per year
Flotation and Check Clearing
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Disbursement Float: The value of the checks that have been written
and disbursed but have not yet fully cleared through the banking
system and thus have not been deducted from the account on which
they are written.
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Collection Float: The amount of checks that have been received
and deposited but have not yet been made available to the account
in which they were deposited.
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Net Float: The difference between disbursement Float and collection
Float; the difference between the balance shown in the checkbook
and the balance shown on the bank’s book.
Flotation and Check Clearing
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Delays that cause float arise because it takes time for checks (1) to
travel through the mail (mail delay), (2) to be processed by the
receiving firm (processing delay), and (3) to clear through the
banking system (clearing, or availability delay).
Example: Suppose a firm writes, on average, checks in the amount
Taka 5,000 each day, and it normally takes five days from the time
the check is mailed until it is cleared and deducted from the firm’s
bank account. This will cause the firm’s own checkbook to show a
balance equal to Taka 25,000 = Taka 5,000 x 5 days smaller than
the balance on the bank’s records; this difference is called
disbursement float. Now suppose the firm also receives checks in
the amount of Taka 5,000 daily, but it loses three days while they
are being deposited and cleared. This will result in Taka 15,000
Flotation and Check Clearing
of collection float. In total the firm’s net float- the difference
between taka 25,000 positive disbursement float and the Taka
15,000 negative collection float- will be Taka 10,000, which means
the balance the bank shows in the firm’s checking account is Taka
10,000 greater than the balance the firm shows in its own
checkbook.
Accelerating Collections
Customer
mails
payment
Company
receives
payment
Company
deposits
payment
Cash
received
time
Mail delay
Processing
delay
Clearing
delay
Mail float
Processing
float
Clearing
float
Collection float
Flotation and Check Clearing
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To understand this transit process, let us track the flow of cash
and documents in a typical passage from one firm to another in
payment of a debt.
Since the most common method of remittance is by check, we
will use a check remittance as an example.
When the check is received by the firm, the documents enclosed
with the check are removed: the check is then forwarded to the
firm’s bank.
The bank then sends the check to the Bangladesh Bank’s Check
Clearing House, which undertakes to present the check for
payment to the bank on which it was written.
Flotation and Check Clearing
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Why should the firm care about this process? The answer is
that every delay in the receipt of money by the firm lowers the
firm’s returns, and therefore its shareholders’ wealth.
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There are several strategies that firms can use to reduce the
delay in receiving funds, such as –
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Selection of banks with accelerated clearing capabilities
Acceleration of check processing at the firm
Use of electronic collection procedures
Use of lockboxes
Use of Lockboxes
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The most popular technique developed recently to reduce float is
the use of what is called a lock-box.
A “lockbox” is a post office box number to which some or all of
the firm’s customers are instructed to send their checks. The
firm grants permission to its bank to take these checks and
immediately start them in the clearing process.
Using lockbox banking is a cash flow improvement technique in
which you have your customers' payments delivered to a special
post office box instead of your business address.
Judicious placement of lockboxes and instructions to customers
on where to send their checks can also serve to reduce mail and
clearing float substantially.
Overview of Lockbox Processing
Corporate
Customers
Corporate
Customers
Post Office
Box 1
Corporate
Customers
Local Bank
Collects funds
from PO Boxes
Envelopes opened;
separation of
checks and receipts
Details of receivables
go to firm
Deposit of checks
into bank accounts
Firm processes
receivables
Bank clears checks
Post Office
Box 2
Corporate
Customers
Sample of Lockbox Process
The Decision to Establish a Lock-Box
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Essentially the decision to establish a lock-box is based on the
"yield" that could be realized on the freed funds vis-à-vis the
cost of the arrangement.
The equation is:
Where, V = yearly dollar volume of credit sales; t1 = new float
period; t2 former float period; T = applicable corporate income
tax rate; H = the total number of checks sent to the lock-box
yearly; h = handling fee, usually, 2-7 cents per item; c = the
check cashing fee, usually about 10-15 cents per item; W = the
total number of wire transfers per year; w = the wire transfer
cost; M = minimum balance (M).
The Decision to Establish a Lock-Box
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Suppose a firm in New York does business with firms in Los
Angeles area, and the following values for the variables hold.
Should the firm utilize lock-box in Los Angeles?
V = $18,000,000 per year
t2= 9 days
t1 = 3 days
i = .08
T = .50
H = 3000 items per year (expected)
h = $0.04
c = $0.12
W = 260
w = $3
M = $60 per item = $180,000
Problems with Lockboxes
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While lockboxes are very useful, not all firms will find them of
advantage. These boxes give customers two mailing addresses:
the lockbox (for checks) and the firm’s usual business address
(for all other documents) which may lead to misrouting of
documents to the box that the firm would prefer to go directly
to its business.
In many financial institutions, the individuals in the lockbox
area are the newest employees, part-timers, poorly supervised,
poorly paid, not well-trained, and are vulnerable to temptation,
and that has led to the latest fraud wave.
Problems with Lockboxes
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Authorities have uncovered a large number of instances where
employees working in lockbox areas have been paid a fee by
criminals to turn over copies of the checks sent to the lockbox.
The copies equip the thieves to create counterfeit checks account holder's name, address, phone number, account
number, bank name, bank routing number, check number and
an example of an accepted signature on the account.
Cash Concentration Strategies
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Once the remittances from the firm’s customers have been
received and cleared, the resulting cash balances are available
in the firm’s lockbox (depository) banks.
It is useful for the firm to gather these balances from the
lockbox banks into a central bank account. The process of
collecting funds is called cash concentration.
There are two reasons why cash concentration is advantageous:
1.
2.
The collection process results in a larger pool of funds, which
can be invested in an interest-earning investment.
With all cash in a central location, keeping track of the cash
(controlling the cash) is considerably simplified.
Disbursement Management
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Disbursement management addresses the efficient paying out
of this cash once it is concentrated.
The firm’s objective in disbursement management is to retain
the cash for as long as possible. In this way, the firm will have
the maximum amount of funds available for investment and
transactional purposes.
But there are some problems if we retain the cash for long
time. Because the maximization of disbursement period will not
go unnoticed by sophisticated creditors for very long. When it is
noticed, it will negatively affect relations with these creditors,
reducing the firm’s bargaining power with them.
Delaying Disbursements
Firm prepares
check to supplier
Post Office
processing
Delivery of check
to supplier
Deposit goes to
supplier’s bank
Bank collects funds
1.
Write check on a distant bank.
2.
Hold payment for several
postmarked in office.
3.
Call supplier firm to verify statement
accuracy for large amounts.
4.
Mail from distant post office.
5.
Mail from post office that requires a great
deal of handling.
days
after
Disbursement Management
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Moreover, practice of lengthening disbursement float is regarded
as being somewhat unethical, rather than as a legitimate
business strategy. Firms that use this strategy will find their
reputations with potential suppliers and others damaged.
The firm has several available sets
disbursement management, such as:
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Management of disbursement float
Use of zero-balance accounts
Use of controlled disbursing
of
techniques
for
Disbursement Management
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Float is defined as the difference between the book balance and
the bank balance of an account.
The time between the moment you write the check and the time
the bank cashes the check there is a difference in your book
balance and the balance the bank lists for your checking
account. That difference is float.
This float can be managed. If you know that the bank will not
learn about your check for five days, you could take the $100
and invest it in a savings account at the bank for the five days
and then place it back into your checking account "just in time"
to cover the $100 check.
Disbursement Management
Time
Book Balance
Bank Balance
Time 0 (make deposit)
$500
$500
Time 1 (write $100 check)
$400
$500
Time 2 (bank receives check)
$400
$400
Float is calculated by subtracting the book balance from the bank
balance.
Float at Time 0: $500 - $500 = $0
Float at Time 1: $500 - $400 = $100
Float at Time 2: $400 - $400 = $0
Disbursement Management (Payables
Concentration)
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Zero-Balance Accounts - A checking account in which a balance of zero
is maintained by automatically transferring funds from a master account in
an amount only large enough to cover checks presented. A zero-balance
account is used by corporations to eliminate excess balances in separate
accounts and maintain greater control over disbursements.
It is a special checking account used for disbursements that has a balance
equal to zero when there is no disbursement activity.
Controlled Disbursement Account - It helps you manage your
company's daily cash position by providing you with early morning
notification of check clearings and same-day funding capabilities. A
controlled disbursement account lets you maximize your investment and
borrowing opportunities while gaining control over outgoing cash flow.
Disbursement Management (Payables
Concentration)
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It is a checking account in which funds are not deposited until
checks are presented for payment, usually on daily basis. 5