On Cash Collection, Disbursement and Float

Credit & Financial Management Review, Fourth Quarter 2003 by Joyce, William B

Abstract:

The cash shown in the company ledger is not the same as the available balance in its bank account. The difference is the net float. Cash collection and disbursement involves some interesting and important decisions. If you can predict how long it will take checks to clear, you may be able to play the float and get by a smaller cash balance. You can also manage the float by speeding up collections and slowing down payments. Concentration banking and lock-box banking reduce mailing time and the time required to clear checks. However, delays that help the payer, hurt the recipient. Recipients try to speed up collections. Payers try to slow down disbursements. Both attempt to minimize net float.

Introduction

Cash collection and disbursement involves some interesting and important decisions. Companies don't keep their cash in a little tin box; they keep it in a bank deposit. To understand how they can make best use ofthat deposit, you need to understand what happens when companies withdraw money from their account or pay money into it.

Float

Suppose that juice Industries has $ 1 million in a checking account with its bank. It now pays one of its suppliers by writing and mailing a check for $200,000. juice's records are adjusted to show a cash balance of $800,000. Thus, juice is said to have a ledger balance of $800,000. But juice's bank won't learn anything about this check until the supplier has received it, the supplier has deposited it its bank, and finally presented to juice's bank for payment. During this time, juice's bank continues to show in its ledger that the company has a balance of $1 million.

While the check is clearing, juice obtains the benefit of an extra $200,000 in the bank. This sum is often called disbursement float, or payment float: juice's ledger balance of $800,000 plus payment float of $200,000 equals the bank's ledger balance $1,000,000.

Float sounds like a great idea: every time juice spends money, it takes the bank a few days to catch on. Unfortunately, float can also work in reverse. Suppose that in addition to paying its supplier, juice receives a check for $100,000 from a customer. juice first processes the check and then deposits it in the bank. At this point both Juice and the bank increase the ledger balance by $ 100,000: Juice's ledger balance $900,000 plus the Bank's ledger balance $1,100,000

But this money isn't available to Juice immediately. The bank doesn't actually have the money in hand until it has sent the check to the customer's bank and received payment. Since the bank has to wait, it makes Juice wait too: usually one or two business days. In the meantime, the bank will show that Juice still has an available balance of only $1 million. The extra $100,000 has been deposited but is not yet available. It is known as availability float: Juice's ledger balance of $900,000 plus the payment float of $200,000 equals the bank's ledger balance of $1,100,000, which equals the available balance of $1,000,000 plus the availability float of $100,000.

Notice that Juice gains as a result of the payment float and loses as a result of availability float. The net float available to Juice is the difference between payment and availability float: net float equals payment float less availability float. In this example, the net float is $100,000. Juice's available balance is $100,000 greater than the balance shown in its ledger.

Valuing Float

Float results from the delay between Juice writing a check and the reduction in its bank balance. The amount of float will therefore depend on the size of the check and the delay in collection.

For example, suppose that Juice firm writes checks worth $100,000 per day. It may take 2 days to mail these checks to its suppliers, who then take two days to process the checks and deposit them with their bank. Finally, it may be a further two days before the supplier's bank sends the check to Jbank, which then debits Juice's account. The total delay is 6 days and the payment float is 6 times $100,000 = $600,000. On average, the available balance at the bank will be $600,000 more than is shown in juice's ledger.

Financial management is concerned not only with juice's ledger balance but also with the available balance. If Juice knows that it is going to be a week before some of its checks are presented for payment, Juice may be able to get by on a smaller cash balance. The smaller Juice can keep its cash balance, the more funds Juice can hold in interest-earning accounts or securities. This concept can be referred to as "playing the float".

Juice can increase its available cash balance by increasing its net float. This means that Juice wants to ensure that checks received from customers are cleared rapidly and those paid to suppliers are cleared slowly. Perhaps this may sound trivial, yet it can be substantial. If Juice's daily sales average over $1 million and if it could speed up collections by one day, and the interest rate is .012 percent per day (about 4.4 percent per year), it would increase earnings by 0.00012 times $1 million = $120 per day.