1. 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.

3. Cash Flow Timeline The firm is a system of cash flows.
These cash flows are unsynchronized and uncertain.
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.

4. Float
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.

5. Types of Float Mail Float Processing Float
The time it takes the firm to receive the mailed remittance.
Influenced by holidays, weekends, weather, etc.
Processing Float
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).

6. Cash Collection Timeline

7. The Importance of Float
Eliminating float is impossible, but measuring and managing it is critical.

8. Payment & Collection Systems
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.

9. Cash Collection Systems
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.
The firm is losing the use of $7 million per day.
Given an 10% opportunity cost, the annual cost of float is:
$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

10. Cost of Float: Dollar-Day Method
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 (+/-).

11. Cost of Float: Dollar-Day Method
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.
Idle funds daily throughout the month
Or, ($1,751,000/30) × 5.49 × 8%

12. Cash Collection Systems
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.

13. Types of Collection Systems
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.

14. Collection System Cost Factors
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

15. Collection System Example
A firm has established a Company Processing Center and is choosing between a centralized and decentralized collection system.

16. Collection System Example
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.

17. Treasury Management Services
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.

18. Types of Float Earlier collection float was divided into three parts:
Mail
The time it takes the firm to receive the mailed remittance.
Processing
The time it takes to process and deposit the remittance.
Clearing (Availability)
The time it takes to convert the deposit to cash.
Treasury Management Services can improve all three.

19. Cash Collection Systems
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.

20. Cash Collection Systems
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.

21. Cash Collection – Lockbox System
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 low- volume, 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.
Wholesale v. Retail Lockbox – A “Wholesale” lockbox has non-standard, high dollar, company-to-company remittances that are processed manually. A “Retail” lockbox has standardized remittances (magnetic data), so can be processed in an automated fashion. Low dollar amounts can be cost-justified given the automated processing.

22. Lockbox Analysis Example
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.

23. Lockbox Analysis Example
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

24. Lockbox Analysis Example
Select Bank 2