Chapter 27

Cash Management

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Asia Global Edition Inc. All rights reserved.
Key Concepts and Skills
 Understand the importance of float and how it
affects the cash balance
 Understand how to accelerate collections and
manage disbursements
 Understand the advantages and disadvantages of
holding cash and some of the ways to invest idle
cash

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Chapter Outline
27.1 Reasons for Holding Cash
27.2 Understanding Float
27.3 Cash Collection and Concentration
27.4 Managing Cash Disbursements
27.5 Investing Idle Cash

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Reasons for Holding Cash
 Speculative motive – hold cash to take advantage of
unexpected opportunities. Eg attractive interest rates,
favorable exchange rate
 Precautionary motive – hold cash in case of
emergencies
 Transaction motive – hold cash to pay the day-to-
day bills and normal day functions of the company.
Eg wages, salaries

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Reasons for Holding Cash
 Trade-off – cash to be invested in bank or any other
marketable securities vs. cash used for other
purpose

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Understanding Float
 Float – difference between cash balance recorded in the cash
account and the cash balance recorded at the bank. This is
due to certain reason of check being written haven’t yet been
presented to the bank for payment
 Disbursement float
 Generated when a firm writes checks
 Causing decrease in the firm’s book balance but no changes in
its available balance in the bank account, until the check is
cleared and presented to the bank for payment
 Thus, Available balance at bank – book balance > 0
 Disbursement Float = Available balance at bank – book
balance

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Understanding Float
 Collection float
 Check received by firm create collection float
 Check received by firm increase book balance but does not
immediately change available balances. Available balances
only increase once the bank credits the account
 Available balance at bank – book balance < 0
 Collection Float = Available balance – book balance
 Net float is the sum of firm’s payment (disbursement)
activities and collection activities
 Net float = disbursement float + collection float
 +ve float addressing firm’s disbursement float exceeds
collection float which means available balance exceeds book
balance
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Example: Types of Float
 You have $3,000 in your checking account.
You just deposited $2,000 and wrote a check
for $2,500.
 What is the disbursement float?
 What is the collection float?
 What is the net float?
 What is your book balance?
 What is your available balance?

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Example: Types of Float
 Disbursement float = Available balance at bank – book balance >0
= $2500 - $0 = $$2500
 Collection float = Available balance at bank – book balance < 0
= $0 - $2000 = -$2000
 Net float = disbursement float + collection float
= 2500 – 2000 = $500
 Book balance = balance in checking account + deposited money –
sum cheque written
= $3000 + 2000 – 2500 = $2500
 Available balance = net float + book balance
 = $500 + $2,500 = $3000

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Example: Measuring Float
 Size of float depends on the dollar amount and the time delay
 Delay = mailing time + processing delay + availability delay
 Mailing time: time during which check’s collection & disbursement are
trapped in the postal system
 Processing delay: time for the receiver of a check to process the payment
& deposit into the bank
 Availability delay: time required to clear a check through banking system
 Suppose you mail a check each month for $1,000 and it takes 3 days to
reach its destination, 1 day to process, and 1 day before the bank makes
the cash available
 What is the average daily float (assuming 30-day months)?
 Method 1: (3+1+1)(1,000)/30 = 166.67
 Method 2: dollar value with float days in a month + dollar value with
no float days in a month
= (5/30)(1,000) + (25/30)(0) = 166.67
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Example: Cost of Float
 Cost of float – opportunity cost of not being able to use the
money, in which the firm can earn interest in the cash if it
were available for investing
 Suppose the average daily receipts is $3 million with a
weighted average delay of 5 days.
 What is the total amount unavailable to earn interest?
 Average daily float = 5*3 million = 15 million (on a typical day, there is
$15 mil that is not earning interest
 What is the NPV of a project that could reduce the delay by 3 days if
the cost is $8 million?
 Immediate cash inflow = 3*3 million = 9 million
 NPV = 9 – 8 = $1 million

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Cash Collection
Payment Payment Payment Cash
Mailed Received Deposited Available

Mailing Time Processing Delay Availability Delay

One of the goals of float management is to try to reduce the

12

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Cash Collection
• Reducing mailing time –illustration of how lockboxes can
reduce mail delay by having customers mail their
payments to PO boxes that are closer to where they live.
The lockboxes is maintained by the local bank
• The processing delay is also reduced because bank
employees process the checks instead of the company
doing it and then taking the checks to the bank.
• Cash concentration – reduce management time by having
a systematic process for moving cash received in the
lock-boxes to a central account. Allows the company to
maintain smaller cash balances overall.
13

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Example: Accelerating Collections –
Part I
 Your company does business nationally, and currently, all checks
are sent to the headquarters in Tampa, FL. You are considering a
lock-box system that will have checks processed in Phoenix, St.
Louis and Philadelphia. The Tampa office will continue to process
the checks it receives in house.
 Using the lockbox system will reduce the collection by 2 days on
average, from 5 days to 3 days
 Daily interest rate on T-bills = .01%
 Average number of daily payments to each lockbox is 5,000
 Average size of payment is $500
 The processing fee is $.10 per check plus $10 each day to wire funds
to a centralized bank at the end of each day.

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Example: Accelerating Collections –
Part II
 Benefits
 Average daily collections = 3 days (5,000)(500) = 7,500,000
 Increased bank balance = 2 days (7,500,000) = 15,000,000
 Costs
 Daily cost = 0.1(5000 daily payment x 3 days) + 3 days*10 = 1,530
 Present value of daily cost = 1,530/.0001 = 15,300,000
 NPV = 15,000,000 – 15,300,000 = -300,000
 The company should not accept this lock-box proposal

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Cash Disbursements
 A good managing cash is to have slower cash disbursement.
However slowing down payments can increase disbursement
float – but it may not be ethical or optimal to do this. Or else ;
the firm may lose cash discounts by paying late and this can be
very expensive
 In this case , controlling disbursement can be done by paying
minimum amount that is considered necessary and not in excess.
2 approaches in achieving this goal
 Zero-balance account
 Controlled disbursement account

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Cash Disbursements
Zero-balance account
The firm cooperate with bank in maintaining a master account & a set of
subaccounts
The money from master account will be transferred to subaccount for the
purpose of paying minimum amount owing, which means firm practicing zero
balance until payment is required
With zero-balance account, the firm keeps a single safety stock of cash in a
master account and transferred the fund into the disbursement account as
needed.

Controlled disbursement account