Credit Management and Cash Collections and Disbursements

Credit & Financial Management Review, First Quarter 2007 by Joyce, William B

Abstract

Many purchases are still paid for by check. Checks create float, and float needs to be managed. Credit managers seek to speed up collections while also controlling the disbursements of their own firms. Credit managers need to understand electronic funds transfers and international cash management. While electronic funds transfers are still relatively few in number, but they are increasingly substantially in terms of value transferred. Finally, international cash management may play an increasingly important role for credit managers as more firms compete on an international basis.

Introduction

The majority of small face-to-face purchases are made with coins or dollar bills. The most popular alternative in the United States for retail purchases is to pay by check. Each year individuals and firms write about 70 billion checks (Bank for International Settlements, 1999).

The United States is unusual in this heavy use of checks. For example, consider retail payment methods in the United States and Holland. Checks are almost unknown in Holland. Most payments there are made by debit cards, direct debit, or credit transfer. Debit cards allow the cardholder to transfer money directly to the receiver's bank account. With a credit transfer the payer initiates the transaction, for example by giving her bank a standing order to make a regular payment. With a direct debit the transaction is initiated by the payee and is usually processed electronically.

How Checks Create Float

How does the firm's cash balance change when it writes or deposits a check? Suppose that the Juice Company has $1 million on demand deposit with its bank. It now pays one of its suppliers by writing and mailing a check for $200,000. The company's ledgers are immediately adjusted to show reflect a cash balance of $800,000. But the company's bank will not learn anything about this check until it has been received by the supplier, deposited at the supplier's bank, and finally presented to Juice's bank for payment. Checks deposited with a bank are cleared through the Federal Reserve clearing system, through a correspondent bank, or through a clearinghouse of local banks. During this time Juice's bank continues to show in its ledger that the company has a balance of $1 million. The company obtains the benefit of an extra $200,000 in the bank while the check is clearing. This sum is often called payment, or disbursement float.

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

Credit managers should be concerned with the available balance, not with the Juice's ledger balance. If the credit manger knows that it is going to be a week or two before some of Juice's checks are presented for payment, the credit manager may be able to get by on a smaller cash balance. This game is often called playing the float.

Credit managers can increase Juice's available cash balance by increasing Juice's net float. This means that the credit manager wants to ensure that checks paid in by customers are cleared rapidly and those paid to suppliers are cleared slowly. Perhaps this may sound like rather small beer, but think what it can mean to a big manufacturing company. If Walter Company's daily sales average about $450 million. Therefore if it can speed up the collection process by one day, it frees $450 million, which is available for investment or payment to Walter's stockholders (Epstein 2001).

Some financial managers have become overenthusiastic in managing the float. In 1985, the brokerage firm E. F. Hutton pleaded guilty to 2,000 separate counts of mail and wire fraud. Mutton admitted that it had created nearly $ 1 billion of float by shuffling funds between its branches, and through various accounts at different banks. These activities cost the company a $2 million fine and its agreement to repay the banks any losses they may have incurred.

Managing Float

Float is the child of delay. Actually there are several kinds of delay, and so people in the cash management business refer to several kinds of float. The time between when a check is mailed and the check is received is mail float. The time between when the check is received and when the check is deposited is processing float. The time between when the check is deposited and when the cash is available to the recipient is availability float, and the time between when the check is deposited and when the check is charged to the payer's account is presentation float. The delays causing availability float and presentation float are equal on average but can differ from case to case.

Of course credit managers try to reduce delay to get available cash sooner while cash managers prefer delay because they can use their cash longer. Another way of saying this is delays that help the payer hurt the recipient. Recipients try to speed up collections. Payers try to slow down disbursements.