Controlling the Collection and Disbursement of Cash - Financial Management

Cash Collection and Disbursement

The cash collection and disbursement processes provide a firm two areas in which it can economize on cash holdings. For example, the sales of Briggs & Stratton average about $5 million per business day. If the company can speed up collections by only one day, the cash balance will increase by $5 million, and these released funds can be invested in other current assets or in fixed assets. If this additional cash can be invested to yield a 5 percent return, it will generate added income of $250,000 per year (5% *$5 million).

Managing Cash Collection and Disbursement

Cash collection and disbursement policies are designed to reduce a firm’s liquid asset balances (cash and marketable securities) by exploiting imperfections in the collection and payment process. The objective is to speed up collections and slow down disbursements. Financial managers should be aware that policies designed to speed up collections and slow down disbursements are highly competitive. If all firms were to employ the same procedures, the net benefit would be zero. Thus, incremental benefits associated with procedures designed to control collections and disbursements will accrue only to the most aggressive and progressive firms. Similarly, cash managers who do not do at least as much as the average firm in speeding up collections and slowing disbursements will find their firms at a competitive disadvantage.

The primary objective of cash collection involves expediting collections by reducing the lag between the time customers pay their bills and the time the checks are collected. In contrast, the primary objective of cash disbursement is to slow payments so that the firm can keep the funds invested or in the bank as long as possible. Expediting collections and slowing disbursements help increase a firm’s cash balance and provide it with funds to use for other profitable investments. Policies designed to control collections and disbursements take advantage of the float present in the payment and disbursement system.


A firm’s cash balance as shown on the bank’s books generally differs from that shown on the firm’s own books. This difference is known as float and represents the net effect of the delays in the payment of checks a firm writes and the collection of checks a firm receives. Checks written by a firm result in disbursement, or positive, float; that is, an excess of bank net collected balances over the balances shown on a firm’s books.

In contrast, collection float, or negative, float arises from the delay between the time a customer writes a check to a supplier or other payee and the time the payee actually receives these funds as collected balances (which are spendable). Action being taken by the Federal Reserve System and the rapid progress being made with electronic payment systems means that float will be less important over time. However, until these developments virtually eliminate float, financial managers must understand the sources of float so that they can take legal actions to benefit from it.

There are three primary components, or sources, of float:

  1. Mail float is the delay between the time a payment is sent to the payee through the mail and the time that payment arrives at the payee’s office.
  2. Processing float represents the delay between receipt of payment from a payer and the deposit of that receipt in the payee’s account.
  3. Check -clearing float is the delay between the time a check is deposited in the payee’s account and the time the funds are available to be spent. Checks processed through the Federal Reserve System are “cleared” in two days or less, although the depositor’s bank may not make the funds available quite that fast.

illustrates the main steps in the cash collection process. The total time involved in this process is a combination of mailing (float) time, company processing (float) time, and check-clearing (float) time, each of which may vary depending on where the firm’s customers and their respective banks are located. Some methods available for reducing the collection float are discussed in the following paragraphs.

Decentralized Collection Centers and Concentration Banks Cash collection systems can be either centralized or decentralized. In the centralized system, customers are instructed to send their payments to the firm’s headquarters. In the decentralized system, customers mail their payments to a nearby collection center, which is strategically located to minimize mail delay. The collection center then deposits the checks in a local bank and reports this information to the firm’s headquarters. Because most of the checks are drawn on banks located in the same geographical area as the collection center, check-clearing float is reduced. Each business day, funds in excess of the amount necessary to compensate the local bank for its services are transferred to an account in a concentration bank, where the firm maintains a disbursement account upon which checks are written.

Concentration banking is the use of decentralized collection centers and local banks to collect customer payments. A trade-off exists between the number of collection centers and the potential savings realized. The more collection centers used, the less time is required to convert customers’ checks into collected balances. However, these savings from faster collections are offset by the direct fees involved, the opportunity costs of the compensating balances the firm must maintain at each local bank, or both. Financial managers must weigh the trade -offs involved in both savings and costs in deciding on the appropriate number and location of collection centers.

Lockboxes illustrates a lockbox collection system. A lockbox is a post office box maintained by a local bank for the purpose of receiving a firm’s remittances. Customers mail payments to this post office box, which is usually no more than a few hundred miles away.The bank empties the box several times each working day, deposits the payments in the firm’s account, puts the checks into the clearing system, and sends the firm a list of the payments received each day.Not only does the lockbox reduce mailing time, but it also eliminates company processing time because the checks are deposited and begin the clearing process before the company’s accounting department processes the payments received, rather than after processing them. The bank normally charges a fee for this service, requires a compensating balance, or both. Funds in excess of the bank’s compensating balance requirement are transferred each day to a master collection account in a concentration bank.

Cash Collection Process

Cash Collection Process

The decision to establish a lockbox collection system requires a comparison of the associated benefits and costs. If the earnings on the funds released by the acceleration of collections exceed the forgone returns on the required compensating balances, the service fees charged by the lockbox bank, or both, the establishment of a lockbox collection system is profitable. If the number of checks handled is small and the dollar amount of each check is large, a lockbox arrangement is very beneficial to the firm. Under these conditions the bank’s workload is light, and the associated service fees, compensating balances, or both, are small. However, when large numbers of checks with small dollar amounts are involved—for example, in the case of oil company credit cards—a lockbox system may not be profitable. Under these conditions, the opportunity costs on the required compensating balances, the service fees, or both may exceed the earnings the firm realizes from having the funds available a few days earlier.

Cash Collection Process

The lockbox decision can be illustrated with the following example. Suppose that the Mutual Life Insurance Company of New York (MONY) currently receives and processes all customer payments at its corporate headquarters in New York City (that is, a centralized system). The firm is considering establishing a bank lockbox collection system for seven southeastern states—Florida, North Carolina, South Carolina, Tennessee, Alabama, Georgia, and Mississippi —that would be located in Atlanta. The lockbox would reduce average mailing time for customer payments from 3 days to 11⁄2 days, check-processing time from 2 days to 1 day, and clearing time from 3 days to 11⁄2 days. Annual collections from the southeastern region are $91.25 million, and the average number of payments received total 550 per day (assume 365 days per year). A bank in Atlanta has agreed to process the payments for an annual fee of $15,000 plus $0.10 per payment received.

This bank would not require a compensating balance. Assuming an 8 percent opportunity cost for released funds, should MONY use the lockbox collection system?

Lockbox Collection System

Lockbox Collection System

shows an analysis of this decision. In Step A, the amount of funds released ($1 million) is found by multiplying average daily collections ($250,000) by the reduction in collection time (4 days). The annual (pretax) earnings on the released funds ($80,000) are found in Step B by multiplying the amount of funds released ($1 million) by the opportunity cost of funds (0.08). The annual bank processing fee ($35,075) is computed in Step C as the sum of fixed costs($15,000) and variable costs ($20,075). Finally, in Step D, the net (pretax) benefits of establishing a lockbox system ($44,925) are computed by deducting the annual bank processing fee ($35,075) from the earnings on the released funds ($80,000). Because the net (pretax) benefits are positive, MONY should employ the lockbox collection system.

Wire Transfers and Depository Transfer Checks Once deposits enter the firm’s banking network, the objective is to transfer surplus funds (that is, funds in excess of any required compensating balances) from its local (collection) bank accounts to its concentration (disbursement) bank account or accounts. Two methods used to perform this task are wire transfers and depository transfer checks.

With a wire transfer, funds are sent from a local bank to a concentration bank electronically through the Federal Reserve System or a private bank wire system.Wire transfers are the fastest way of moving funds between banks because the transfer takes only a few minutes and the funds become immediately available (that is, they can be withdrawn) to the firm upon receipt of the wire notice at the concentration bank.Wire transfers eliminate the mailing and check-clearing times associated with other funds-transfer methods. Some firms leave standing instructions with their local collection) banks to automatically wire surplus funds on a periodic basis (for example, daily, twice a week, and so on) to their concentration bank. Also, some firms specify in their sales contracts that customers must wire their payments on the due dates.

Mutual Life Insurance Company of New York (MONY) Analysis of the Decision

Mutual Life Insurance Company of New York (MONY) Analysis of the Decision

Wire transfer of funds is available to member banks of the Federal Reserve System and to nonmember banks through their correspondent banks. The cost to corporate customers to send a wire transfer at most banks ranges from $10 to $25. A similar charge is made to receive and process a domestic wire transfer. For a firm with multiple collection centers that use wire transfers on a daily basis, the annual costs can be substantial. Consequently, this method of transferring funds should be used only when the incremental value of having the funds immediately available exceeds the additional cost, relative to alternatives, such as depository transfer checks.

A mail depository transfer check (DTC) is an unsigned, nonnegotiable check drawn on the local collection bank and payable to the concentration bank. As it deposits customer checks in the local bank each day, the collection center mails a depository transfer check to the concentration bank authorizing it to withdraw the deposited funds from the local bank. Upon receipt of the depository transfer check, the firm’s account at the concentration bank is credited for the designated amount. Depository transfer checks are processed through the usual check-clearing process.

Although the use of depository transfer checks does not eliminate mailing and check-clearing time, it does ensure the movement of funds from the local collection center banks to the concentration bank in a timely manner. Also, the cost of this method of transferring funds is low; often the only cost involved is postage. An electronic depository transfer check (EDTC) can also be used to move funds from a local bank to a concentration bank. The process of transmitting deposit information to a concentration bank is similar to that for mail DTCs just described, except that the information is sent electronically through an automated clearinghouse, such as the automated clearinghouse (ACH) system of the Federal Reserve (Fedwire) or the Clearing House

Interbank Payments System (CHIPS). These systems eliminate the mail float in moving funds from the local bank to a concentration bank. Funds transferred through an automated system are available for use by the firm in one day (or less).

Special Handling of Large Remittances Firms that receive individual remittances in the multimillion-dollar range may find it more profitable to use special courier services to pick up these checks from customers (rather than having their customers mail the checks) and present them for collection to the banks upon which they are drawn.

Use of Preauthorized Checks A preauthorized check (PAC) resembles an ordinary check except that it does not require the signature of the person (or firm) on whose account it is being drawn. This system is especially useful for firms that receive a large volume of payments of a fixed amount each period. Insurance companies, savings and loans, charitable institutions, and leasing firms make extensive use of this collection procedure. When preauthorized checks are used, the payer agrees to allow the payee (the firm that is owed the money) to write a check on the payer’s account and deposit that check immediately for collection at an agreed-upon time. Preauthorized checks have the advantages of completely eliminating the mail float, reducing billing and collecting expenses, and making the cash flows for both parties highly predictable. Many payers like preauthorized check systems because they do not have to bother to write a check each month.

Slowing Disbursements

illustrates the principal steps involved in the cash disbursement process. Several ways in which a firm can slow disbursements and keep funds in the bank for longer periods of time are discussed in the following paragraphs.

Scheduling and Centralizing Payments A firm should pay bills on time—not before or after they are due. There is no significant benefit to be received by paying bills before they are actually due, unless a cash discount is offered for early payment.6 Payments made ahead of time lower the firm’s average cash balance, whereas late payments can impair the firm’s credit rating. Centralizing payments from disbursement accounts maintained at a concentration bank helps minimize the amount of idle funds a firm must keep in local field offices and divisional bank accounts.

A number of firms have set up zero-balance systems to use disbursement float more effectively. In a zero-balance system, a master, or concentration, account is set up to receive all deposits coming into the zero-balance system. As checks clear through the zero-balance accounts on which they are issued, funds are transferred to these accounts from the master account. These disbursement accounts are called zero-balance accounts because exactly enough funds are transferred into them daily to cover the checks that have cleared, leaving a zero balance at the end of the day.

In general, all disbursements for accounts payable, payroll, and whatever other purposes the firm desires are issued from these zero-balance accounts. For a zero-balance system to operate effectively, a firm must have a well-developed network for reporting deposits and disbursements, as well as a close working relationship with its bank. In making the decision to put into effect a more efficient cash disbursement system, such as a zero -balance system, a company’s financial managers need to compare the returns that can be earned on released funds to the cost of implementing the system.

Drafts A draft is similar to a check, except that it is not payable on demand. Instead, when a draft is transmitted to a firm’s bank for collection, the bank must present the draft to the firm for acceptance before making payment. In practice, individual drafts are considered to be legally paid automatically by the bank on the business day following the day of presentation to the firm, unless the firm returns a draft and explicitly requests that it not be paid. Once the draft has been presented, the firm must immediately deposit the necessary funds to cover the payment.

The use of drafts rather than checks permits a firm to keep smaller balances in its disbursement accounts because funds do not have to be deposited in them until the drafts are presented for payment. Normally, drafts are more expensive to use than checks. The lower account balances and higher processing costs cause banks to impose service charges on firms using drafts; this cost must be included in the analysis of the benefits and costs of using drafts to pay bills.

Cash Disbursement Process

Cash Disbursement Process

Drafts are now used primarily to provide for centralized control over payments authorized in field offices, rather than as a means of slowing disbursements. For example, a claims agent for Nationwide Insurance might issue a draft to provide for quick settlement of an insurance claim. The claims agent does not have the authority to write a check against Nationwide’s checking accounts. By issuing a draft, centralized control can be maintained over these disbursements. The Federal Reserve System requires a firm to transfer funds to the bank through which payment is to be made as soon as the drafts are presented to the firm.

Maximizing Check-Clearing Float Some firms make payments to suppliers from checking accounts located a long distance from the supplier. For example, an East Coast supplier


Cash Management

Financial managers are confronted with legal and ethical issues as they make cash collection and disbursement decisions. For example, a large firm, such as General Motors (GM) might be tempted to systematically be a few days late in making payments to a small supplier.GM managers may be confident that the small firm will not risk damaging its supply relationship with GM over payment delays of a few days. Similarly, a cash manager may take advantage of weak control mechanisms in its banks and make short-term investments using uncollected funds.

E.F. Hutton’s managers got into a lot of trouble with this type of activity. In 1985, E.F. Hutton & Company, a large securities brokerage firm (now part of Citigroup’s Smith Barney securities brokerage subsidiary), pleaded guilty to federal fraud charges involving the operation of a massive check-writing scheme to obtain money from many of its 400 banks without paying interest. The firm pleaded guilty to 2,000 counts of mail and wire fraud and agreed to pay more than $10 million in criminal fines and restitution to the banks. According to the Justice

Department, Hutton systematically overdrew hundreds of its own accounts in banks throughout the country and intentionally moved money between banks to artificially delay the collection of funds. The scheme involved checks totaling more than $4 billion. By doing this, Hutton was able to use as much as $250 million in interest-free money on some days. According to Justice Department documents, Hutton officials frequently misused bank accounts of its branches by writing checks for amounts in excess of the volume of customer funds deposited in these accounts. Hutton also pleaded guilty to extending the float time during which checks are cleared by setting up a chain of transfers between branch accounts.These transactions, according to the Justice Department, resembled a check -kiting scheme and were carried out illegally without the prior agreement or consent of the banks involved. Indeed, the banks generally did not realize they were victims until they were told by officials from the government.

A good financial manager should be mindful of the legal and ethical effects of the firm’s actions. Legal violations can result in costly fines, embarrassment, and, in some cases, prison terms. Violations of business contracts and the trust built in business transactions may be very costly to a firm’s reputation and its future business relationships. In the Hutton case, not only were key employees prosecuted, but also the firm’s reputation was so damaged that it was forced to combine with another investment bank to avert failure. might be paid with checks drawn on a West Coast bank; this increases the time required for the check to clear through the banking system. Some firms maintain an intricate network of disbursing accounts. Checks are issued from the account most distant from the payee, thereby maximizing check -clearing float.

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