Chapter 20: Working Capital Management

Cash and Marketable Securities Management

Are the most liquid of a firms assets
Cash consists of currency and deposits in
checking accounts
Marketable securities consist of S-T investments
made with idle cash
Investing Idle Cash: The Money Market
The securities normally used for temporary investments
are usually purchased in the money market where short-
term, high quality, marketable securities are traded.
When cash needs are known, securities of specific short-
term maturity may be selected. If cash is needed, money
market securities may be sold quickly, and because
there is little price variability if market interest rates
change, the cost of selling the securities is kept at a
minimum.
One choice of short-term is Treasury bills, which mature
less than 6 months and are the safest money market
securities.
Another choice is high quality investment is commercial
paper, the short-term notes (maturities usually less than
270 days) issued by industrial and financial corporations.
Certificates of deposits (CDs) are short-term notes issued
by commercial banks.
Repurchase agreements (repos), the purchase of
securities under agreement to resell (at a higher price)
are issued by commercial banks when the checking
account of the business is higher than desired. The
money stays in the bank and the business has a
temporary earning investment.
Reasons for Holding Cash and Marketable Securities:
Transactions: Firms use cash to make transactions (pay
bills) until they receive cash from customers.
Precautionary: firms hold cash as a precaution to meet
any unexpected demand for cash.
Future requirements: firms hold cash to meet future
planned needs (eg. capital expenditure, tax payments,
dividend payments, loan payments)
Speculative: firms hold cash to be more flexible ion case
any good investment opportunity comes up. 2
Optimal Cash and Marketable Securities Balance:
Weight the benefits and costs of holding various
balances:
Holding cash and marketable Securities incur an
opportunity cost. The cash in the bank earn very
low rate of return. The firm could have earn
higher return by investing this cash in the firms
operation.
Running short of cash and marketable Securities
also incurs shortage costs:
Foregone cash discounts: Suppliers frequently offer
trade discounts for paying bills early. From a financing
standpoint, the cost of not taking these discounts is very
high, so firms should always have enough cash on hand
to take advantage of them.
Deterioration of the firms credit rating: Credit rating
take into account the level of liquid assets in the firm
(quick ratio and current ratio). An adequate supply of
cash helps keep the firms current and quick ratios high
enough to maintain a good credit rating.
High interest expense: if the firm is not able to pay bills
on time, it will have to pay high financing charges.
Possible financial insolvency: Bankruptcy
Collection and Disbursement of Cash
Managers always try to speed up the collection of cash
from customers and to slow down the disbursements of
cash to supplies and other parties.
Accounts Receivable Management
Credit Policy
Credit standards
Criteria used to screen credit applications: Evaluation
of Credit Applications.
9 Gathering information: financial statements,
credit reports, banks, prior experience.
9 Numerical scoring system (Altman Z score), see
p. 547.
9 Five Cs of credit
Character : assess customer willingness to meet credit
terms
Capacity : customers liquidity position
Capital: customers financial strength and net worth
Collateral: customers assets than can
be used as collateral
Conditions: the general conditions in
the economy.
Controls the quality of accounts: quality of account
means how long the customer takes to repay the credit
granted and the probability of default. The probability of
default is measured by the bad-debt loss ratio which is
the proportion of account receivable that is uncollected.
Credit should be extended if the expected profit from the
credit sale is greater than the expected profit from
refusing credit. If paid as agreed, the profit margin will be
realized on the sale; if payment is not received, the firm
loses the cost of sales. Refusing credit makes no profit.
See Figure 20.1.
Credit terms : Conditions under which credit extended
must be repaid
Credit period :Time allowed for payment
Cash discount: allowed if payment is made within a
specific period of time. It specified as % of the invoiced
amount. For example: credit terms of (2/10, net 30) mean
that customer can deduct 2% of the invoice amount if
payment is made within 10 days from the invoice date. If
payment is not made within the 10 days, then full invoice
amount is due in 30 days from invoice days. Cash
discount is used to speedup the collection of account
receivable.
Collection efforts: Methods employed in an attempt to
collect payment on past due accounts
Balance between leniency and alienating customers
9 Sending notices
9 Telephoning
9 Collection agency
9 Legal action
Monitoring status: perform aging of accounts analysis.
An aging schedule is a report that actually breaks down
a firms receivables by age.
For example, an aging schedule could show what
respective portions of
Refuse credit
Offer credit
Payoff = Rev - Cost
Payoff = - Cost
Customer pays = p
Customer defaults = 1-p
Payoff = 0 Payoff = 04
A/R have been outstanding for less than 10 days, for 11-
30 days, for 31-45 days, for 46-60 days, etc. If a significant
part of the firms receivables are past due, this indicates
that the firm may need to reexamine its collections
policies.
Inventory Management
Types of Inventory
Raw materials inventory
Stores of items used in production
Quantity discounts: by large quantity to get discount
on price
Assure supply in times of scarcity
Work-in-process inventory
Items at some intermediate state of completion
Size related to length and complexity of production
cycle
Finished goods inventory
Items ready and available for sale
Permits prompt filling of orders
Costs Associated with an Inventory Policy
Ordering costs: Costs of placing and receiving an order
of goods, including inspecting shipments, handling
payment, follow up calls and letters.
Carrying costs: Costs of holding inventory for a given
period of time, including storage and handling cost,
obsolescence and deterioration cost, and opportunity
cost of funds invested in inventory.
Stockout costs: Incurred when a firm is unable to fill an
order, including losing sales and the extra cost of placing
special orders or work overtime to produce the needed
product.
Just-in-time inventory (JIT): The firm does not carry
inventory. Once the order is received from customers, the
order for raw material is placed with the supplier and the
product is manufactured. JIT method is used to reduce
inventory cost by supplying Inventory at exactly the right
time and in exactly the right quantities. Example, Dell
Computer Co.
95
Chapter 19
Cash Conversion, Inventory, and Receivables
Management
Answers to Concept Review Questions
1. What does the firms cash conversion cycle represent?
What is the financial managers goal with regard to it?
Why?
The firms cash conversion cycle represents how quickly a
firm turns its product, from paying for inventory to
collecting cash from the customer in payment for finished
goods.
The financial managers goal is reduce the cash
conversion cycle. The longer the cycle, the greater the
need for interim financing to pay for the firms materials
needs. The shorter the cycle, the sooner the firm receives
cash that it can reinvest in the firm. A shorter cycle
minimizes firm costs.
2. How should the firm manage its inventory, accounts
receivable, and accounts payable inorder to reduce the
length of its cash conversion cycle?
The firm should have the least amount of inventory
possible (as long as there are no stockouts which result in
lost sales), the least amount of accounts receivable
(collectaccounts receivable quickly) and the greatest
amount of accounts payable (stretchpayments as long
as possible).
3. What are the general cost trade-offs that the financial
manager must consider whenmanaging the firms
operating assets? How do these costs behave as a firm
considersreducing its accounts receivable by offering
more-restrictive credit terms? How can theoptimum
balance be determined?
There are costs associated with holding too much and
too little of each current asset andliability. For example, if
a firm has a liberal credit policy, it will attract more
customers,resulting in higher sales. However, it will have
the cost of supporting the higher level ofaccounts
receivable and possibly more bad debts. If the firm has
more restrictive creditpolicies, it may lose sales to
competitors with more liberal terms. The firm wants to
findthe amount of each asset that minimizes these
competing costs.
4. What are the general cost trade-offs associated with
the firms level of short-termfinancing? How do these
costs behave when a firm substitutes short-term financing
forlong-term financing? How would you quantitatively
model this decision to find theoptimal level of short-term
financing?
A firm with a great deal of short-term financing will have
reduced liquidity, but will alsohave lower costs, since
short-term debt is generally less expensive than long-term
debt orequity financing. In other words, the greater the
amount of short-term financing, thelower the costs to the
firm. The firm will need to balance its desired liquidity,
for96 Y Chapter 19/Cash Conversion, Inventory, and
Receivables Managementexample, maintaining
minimum current or quick ratio, with its desire to reduce
the costsof obtaining financing.
5. How might the view of the financial manager with
regard to inventory differ from that ofthose in production
and marketing? What is the relationship between
inventory turnoverand inventory investment? Explain.
There are potential conflicts between the finance
function view of inventory and that ofmarketing and
production. The financial manager wants to minimize
inventory. Fundsthat are not tied up in inventory can be
used for positive net present value investment.
The production function, however, wants to ensure that
there is adequate inventory sothat production can run
smoothly, while the marketing function will want
enoughinventory to avoid stockouts. Inventory turnover is
higher when inventory investment islower. Inventory
turnover refers to how many times the warehouse is
emptied and thenfilled up each year. The higher the
inventory turnover, the more efficient the firms use
ofinventory (as long as there are not stockouts which
adversely impact sales.)
6. What is the ABC system? What role does the EOQ
model play in controlling inventory?
How does it capture the opportunity costs associated
with inventory investment?
In the ABC system, inventory is divided into three groups.
A items are those in which thefirm has the largest
investment and therefore the most intensive control. B
items requirethe next largest investment and less intensive
control than the A items, and C itemsrequire the smallest
investment and least intensive control. Separating
inventory allowsthe firm to decide what level and type of
inventory control is needed. The EOQ modelmight be
used to control A group items. This model considers
operating and financialcosts and determines the order
quantity that minimizes overall inventory costs. Thismodel
captures opportunity costs because it includes order
costs and carrying costs, thecost of holding too much
inventory. The model balances carrying and order costs
to findthe optimal level of inventory.
7. Describe from the financial managers perspective the
role of safety stock, reorder points,MRP, MRPII, and a just-
in-time system in managing a firms inventory.
The EOQ model assumes perfect coordination between
supplier and user. In reality, thefirm may not be able to
predict the exact time a new order will arrive. In order to
ensurethat production runs smoothly, the firm may want
to hold safety stocks, extra inventorythat takes into
account the probability of shipment delays and faster-
than-average usage.
The reorder point is lead time in days times daily usage,
and is an estimate of when neworders should be placed.
MRP, or material requirements planning, is a
computerizedsystem to control the flow of resources. It
uses a master schedule to ensure thatproduction needs
are at the right time and place in the correct amounts.
Manufacturingrequirements planning II expands on MRP.
Its computerized system integrates data fromfinancing,
marketing, engineering and manufacturing. It generates
a production plan for
the firm, along with management reports, forecasts and
financial statements. Just-intime is a system with the core
principle that materials should arrive exactly when
theyare needed for production. A computerized system
like MRP can state when thematerials will be needed,
and just-in-time principles states that the materials should
beordered to arrive precisely when the MRP schedule
says the will be needed. JIT canChapter 19/Cash
Conversion, Inventory, and Receivables Management Y
97reduce inventory levels and carrying costs, allowing the
financial manager to invest thesefunds in more
productive uses.
8. Why do a firms regular credit terms typically conform
to those of its industry? On whatbasis other than credit
terms should the firm compete?
A firms credit terms typically conform to those of its
industry. If they did not, thencustomers would be more
likely to patronize competitors with more liberal
creditpolicies. The firm can, however, compete on other
than credit terms. For example, thefirm could offer faster
delivery or higher quality, which might attract more
customerseven if the credit policies were more restrictive.
9. How are the five Cs of credit used to perform in-depth
credit analysis? Why is thisframework typically used only
on high-dollar credit requests?
The five Cs of credit are used to perform in-depth credit
analysis but dont provide aspecific accept or reject
decision. Applying the five Cs requires an analyst
experiencedin reviewing and granting credit requests.
Applying the five Cs is costly and timeconsuming, and
therefore is applied primarily to high-dollar credit
requests.
10. How is credit scoring used in the credit selection
process? In what types of situations is itmost useful?
Credit scoring applies statistically derived weights for key
financial and creditcharacteristics to predict whether a
potential customer will pay in a timely manner. Thescore
measures the applicants overall credit strength. It is most
commonly used bylarge credit card operations, such as
those of banks, oil companies and departmentstores.
11. What are the key variables to consider when
evaluating the benefits and costs of changing credit
standards? How do these variables differ when
evaluating the benefits and costs of changing credit
terms?
When considering changing credit standards, the firm
must look at what impact a changewould have on sales,
costs and overall cash flows. A restrictive credit policy
could costthe firm lost sales, while relaxing standards
could lead to an increase in bad debts. Relaxing credit
standards generally increases sales and bad debt
expense. Tighteningcredit standards lowers accounts
receivable and bad debts but also lowers sales
andprofits.
12. Why do we include only the variable cost of sales
when estimating the averageinvestment in accounts
receivable? Why do we apply an opportunity cost to
thisinvestment to estimate its cost?
We use only variable costs because the model assumes
an increase in sales will not causefixed costs to increase.
There is an opportunity cost of increasing accounts
receivable the higher level of accounts receivable must
be financed and there is a cost associated(interest
expense) with higher levels of financing.98 Y Chapter
19/Cash Conversion, Inventory, and Receivables
Management
13. What are the key elements of a firms credit terms?
What is a key determinant of thecredit terms offered by a
firm?
Credit terms include when the customer must pay and if
the customer receives discountsfor paying before the bill
is due. Credit terms are influenced by the nature of
thebusiness. For example, a firm with perishable times will
have short credit terms, sincethere is little value to
repossessing the items if the bill is not paid on time. A firm
in aseasonal business may use seasonal dating, fitting
credit terms to fit industry cycles.
14. What is a collection policy? What is the typical
sequence of actions taken by a firm whenattempting to
collect an overdue account?
Collection policy refers to the procedures used by a
company to collect overdue accountsreceivable. A firm
may start with a reminder, form letter, telephone call or
visit toencourage customer payment. The company may
suspend further sales until thedelinquent account is made
current. Next, the firm may negotiate with the customer
forpast due amounts and report the customer to credit
bureaus. If the goods were sold with
a lien attached, collateral or corporate or personal
guarantees, the company may pursuethese options to
obtain payment. As a last resort, the account may be
turned over to acollection agency or referred to an
attorney.
15. Why should a firm actively monitor the accounts
receivable of its credit customers? Howdo each of the
following credit monitoring techniques work: (a) average
collectionperiod, (b) aging of accounts receivable, and
(c) payment pattern monitoring?
A firm should actively monitor accounts receivable to
ensure that customers are payingin a timely manner. For
example, are customers complying with the firms credit
termsor are they taking longer to pay than the
companys policies allow? At some point thefirm may
need to turn overdue accounts over to a collection
agency or take legal actionsto collect. By monitoring
average collection policy, the firm can see if its terms
aregenerally being met. For example, if the firm extends
credit for 30 days and it has a 45-day collection period,
then customers on average are significantly slower in
paying thancompany policies allow. Aging of accounts
receivable shows what percent of accountsare not paid
in a timely manner. Payment pattern monitoring is helpful
if the firm hasvery cyclical sales patterns. The payment
pattern is the normal timing in which a firmscustomers
pay their accounts, expressed as a percentage of
monthly sales collected ineach month following the sale.
By tracking patterns over time, the company
candetermine its average pattern.Chapter 19/Cash
Conversion, Inventory, and Receivables Management Y
99
Answers to Self-Test Problems
ST19-1. Aztec Products wishes to evaluate its cash
conversion cycle (CCC). Research by one ofthe firms
financial analysts indicates that on average the firm holds
items in inventoryfor 65 days, pays its suppliers 35 days
after purchase, and collects its receivables after 55days.
The firms annual sales (all on credit) are about $2.1
billion, its cost of goods soldrepresent about 67 percent of
sales, and purchases represent about 40 percent of cost
ofgoods sold. Assume a 365-day year.
a. What is Aztec Products operating cycle (OC) and
cash conversion (CCC)?
b. How many dollars of resources does Aztec have
invested in (1) inventory, (2)accounts receivable, (3)
accounts payable, and (4) the total CCC?c. If Aztec
could shorten its cash conversion cycle by reducing its
inventory holdingperiod by 5 days, what effect would it
have on its total resource investment found inpart b(4)?
d. If Aztec could shorten its CCC by 5 days, would it be
best to reduce the inventoryholding period, reduce the
receivable collection period, or extend the
accountspayable period? Why?
a. Operating cycle = average age of inventory +
average collection period
OC = AAI + ACP
= 65 days + 55 days = 120 days
Cash conversion cycle = operating cycle average
payment period
CCC = OC APP
= 120 days 35 days = 85 days
b. (1) inventory = ($2.1 billion x 67%) x (65/365) = $250.6
million
(2) accounts receivable = ($2.1 billion) x (55/365) = $316.4
million
(3) accounts payable = ($2.1 billion x 67% x 40%) x
(35/365) = $54 million
(4) total resources invested = $250.6 million + $316.4
million - $54 million
= $513.0 million
c. New inventory investment = ($2.1 billion x 67%) x [(65
5)/365] = $231.3 million
Change in resource investment = change in inventory
investment
= $231.3 million - $250.6 million = -$19.3 million
The total resource investment would be reduced by $19.3
million.
d. It would be best to reduce the receivable collection
period because the receivablesaccount for the largest
annual dollar investment$2.1 billionwhereas the
annualinventory investment equals 67 percent of that
amount, and annual purchases equal40 percent of the
inventory investment.
ST19-2. Vargas enterprises wishes to determine the
economic order quantity (EOQ) for a criticaland
expensive inventory item that is used in large amounts at
a relatively constant rate100 Y Chapter 19/Cash
Conversion, Inventory, and Receivables Management
throughout the year. The firm uses 450,000 units of the
item annually, has order costs of$375 per order, and its
carrying costs associated with this item are $28 per unit
per year.The firm plans to hold safety stock of the item
equal to 5 days of usage, and it estimatesthat it takes 12
days to receive an order of the item once placed.
Assume a 365-day year.
a. Calculate the firms EOQ for the item of inventory
described above.
b. What is the firms total cost based upon the EOQ
calculated in part a?
c. How many units of safety stock should Vargas hold?
d. What is the firms reorder point for the item of inventory
being evaluated? (Hint: Be
sure to include the safety stock.)
a. S = 450,000 units; O = $375/order; C = $28/unit/year
EOQ = C2SO = $28
2 * 450,000 *$375
= 12,053,571 = 3,472 units
b. Total cost = (O x S/Q) + (C x Q/2)
= ($375 x 450,000/3,472) + ($28 x 3,472/2)
= $48,603 + $48,608 = $97,211
c. Daily usage = 450,000 365 = 1,233 units
Safety stock = 5 days x 1,233 units/day = 6,165 units
d. Reorder point =(lead time in days x daily usage) +
safety stock
= (12 days x 1,233 units/day) + 6,165 units = 20,961 units
ST19-3. Belton Company is considering relaxing its credit
standards to boost its currentlysagging sales. It expects its
proposed relaxation will increase sales by 20 percent from
thecurrent annual level of $10 million. The firms average
collection period is expected toincrease from 35 days to
50 days and bad debts are expected to increase from 2
percent ofsales to 7 percent of sales as a result of relaxing
the firms credit standards as proposed.
The firms variable costs equal 60 percent of sales and
their fixed costs total $2.5 million
per year. Beltons opportunity cost is 16 percent. Assume
a 365-day year.
a. What is Beltons contribution margin?
b. Calculate Beltons marginal profit from increased sales.
c. What is Beltons cost of the marginal investment in
accounts receivable?
d. What is Beltons cost of marginal bad debts?
e. Use your findings in parts b, c, and d to determine the
net profit (cost) of Beltons
proposed relaxation of credit standards. Should they relax
credit standards?
a. Contribution margin = 1.00 variable cost percentage
= 1.00 0.60 = 0.40 = 40%
b. Marginal profit from increased sales = sales x
contribution margin
= ($10 million x 20%) x 40% = $800,000
c. Cost of marginal investment in accounts receivable:
Investment in accounts receivable = Total variable
cost/A/R turnover
After relaxation: ($12 million x 60%) / (365/50) =
$986,301Chapter 19/Cash Conversion, Inventory, and
Receivables Management Y 101
Before relaxation: ($10 million x 60%) / (365/35) = $575,342
Marginal investment in A/R = $986,301 - $575,342 =
$410,959
Cost of marginal investment in A/R = $410,959 x 16% =
$65,753
d. Cost of marginal bad debts:
Cost of bad debts = annual sales x bad debt expense
rate
After relaxation: $12 million x 7% = $840,000
Before relaxation: $10 million x 2% = $200,000
Cost of marginal bad debts = $840,000 - $200,000 =
$640,000
e. Summary:
Marginal profit from increased sales = $800,000
Less: Cost of marginal investment in A/R = 65,753
Less: Cost of marginal bad debts = 640,000
Net profit from proposed relaxation $ 94,247
Recommendation: Belton Company should relax its credit
standards as proposed
because it will result in an annual increase in profits of
$94,247.
FLOAT
The efficiency of the firm's cash management
programme can be enhanced by the knowledge and
use of various procedures aimed at
a. accelerating cash inflows, and
b. controlling cash outflows
With reference to the control of inflows and outflows,
float is an important technique to reduce the length of
the cash cycle. When a firm receives or makes
payments in the form of Cheque etc., there is usually a
time gap between the time the Cheque is written and
when it is cleared. This time gap is known as float. The
float for the paying firm referes to te ime that elapses
between the point when it issues a Cheque and the
time at which the funds underlying the Cheque are
actually debited in the bank account. For the payee
Firm, float refers to the time between the receipt of the
Cheque and the availability of the funds in its account.
So, float denotes the funds that have been dispatched
by a payer (the firm making the payment) but are not
in a form that payee (the firm receiving the payment)
can spend. The float also exists when a payee has
received funds in a spendable form but these funds
have not been withdrawn from the account of the
payer.

To get an idea of the float mechanism and its utility in
the management of cash inflows and outflows, one
must know the related banking procedure. When a
Cheque is issued by the paying firm, the bank balance
of the firm is not imeediately reduced, rather the bank
reduces the balance only when the Cheque is
presented to it either personally or through the clearing
system.

Similarly, when the firm receives a Cheque from the
customer and deposits the Cheque in the firm's
account, the amount, rather the bank credits the
Cheque amount only when it is cleared by the paying
bank.

The cash balance shown by a firm on its books is called
the book or ledger balance whereas the balance
shown in its bank accunts is called the available or
collected balance. The difference between the
available balance and the ledger balance is referred
to as the float.
3. TYPES OF FLOATS
There are two types of float viz., DISBURSEMENT FLOAT
and COLLECTION FLOAT.
3.1 Disbursement Float

The amount fo Cheque issued but not presented for
payment is kknown as the disbursement float. For
example, suppose that ABC Company has a book
balance as well as available balance of Rs 4 Lac with
its bank, State Bank of India, as on March 31. On April 1
it pays Rs 1 Lac by Cheque to one of its suppliers and
hence reduces its book balance by Rs. 1 Lac.

State Bank of India, however, will not debit ABC
Company account till the Cheque has been presented
for payment on, say, April 6. Until that happens the
firm's available balance is greater thatn its book
balance by Rs. 1 Lac. Hence, between April 1 and April
6 ABC Company has a disbursement float of Rs. 1 Lac.

Disbursement float = Firm's available Bank balance -
Firm's book balance = Rs 4 Lac - Rs. 3 Lac = Rs.1 Lac.
3.2 Collection Float:

The amount of Cheque deposited in the banks, but not
yet cleared, is known as the collection float.

For example, suppose that XYZ Company has book
balance as well as available balance of Rs 5 Lac as on
April 30. On May 1 XYZ Company receives a Cheque
for Rs. 1.5 Lac from a customer which it deposits in the
Bank. It increases its book balance by Rs. 1.5. Lac.
However, this amoung is not available to ABC
Company until its bank presents the Cheque to the
customer's bank on, say, May 5. So, between May 1
and May 5 ABC Company has a collection float of (-)
Rs. 1.5 Lac.

Collection float = Firm's avilable Bank Balance-Firm's
book balance=Rs 5.0 Lac - Rs. 6.5 Lac = (-) Rs. 1.5 Lac.
3.3 Net Float:

The net float at a point of time is simply the overall
difference between the firm's available bank balance
and the balance shown by the ledger account of the
firm. If the net float is positive, i.e., payment float is
more than receipt float, then the available bank
balance exceeds the book balance. However, if the
available bank balance is less than the book balance,
then the firm has net negative float. If a firm has
positive net float (i.e. the payment float is more than
the receipt float), it can issue more Cheque even if the
net bank balance shown by the books of account may
not be sufficient. A firm with a positive net float can use
it to its advantage and maintain a smaller cash
balance than it would have in the absence of the
float. For example, a firm has a payment float of Rs.
1,00,000 and receipt float of Rs, 80,000. This firm has
positive net float, which may be ascertained as follows:

Net float=Payment float-Receipt float = Rs. 1,00,000 -
80,000= Rs. 20,000. The course of action adopted by a
firm to manage the payment and the receipt float is
known as playing the float, which has emerged as an
important technique of cash management in most of
the firms. Float management helps avoiding stagnation
of funds. Money paid by Cheque by customers to the
firm but not yet available to the latter, as it is tied in the
float is a stagnant money. Similarly, Cheque issued but
no presented t the firm's bank is stagnant money. This
can be used by a proper and careful float
management.

Since what matters is the available balance, as a
finance manager you should try to maximise the net
float. This means that you should strive to speed up
colections and delay disbursements.
4. MANAGEMENT OF FLOAT
4.1 Speeding Up Collections

The collection time comprises mailing time, Cheque
processing delay, and the bank's availability delay as
shown in Exhit 1.

When a company receives payments through Cheque
that arrive by mail, all the three components of
collection time are relevant. The financial manager
shouls ttake steps for speedy recovery from debtors
and for this purpose proper internal control system
should be installed in the firmk. Once the credit sales
have been effected, there should be a built-in
mechanisim for timely recovery from the debtors.
Periodic statements should be prepared to show the
outstanding bills. Incentives offered to the customers
for early / prompt payments should be well
communicated to them. Once the cheques / drafts
are received from customers, no delay should be there
in depositing these receipts with the banks. The time
lag in collection of receivables can be considerably
reduced by managing the time taken by postal
intermediaries and banks.

To speed up collection, companies may also use
lockboxes and concentration banking which are
essentially systems for expeditious decentralised
collection.
4.1 Lock Boxes

Under a lock box system, customers are advised to mail
their payments to special post office boxes called
lockboxes, which are attended to by local collection
banks, instead of sending them to corporate
headquarters.

The local bank collects the Cheque from the lock box
once or more a day, deposits the Cheque directly into
the local bank account of the firm, and furnishes
details to the firm.

Thus the lock box system (i) cuts down the mailing time,
because Cheque are received at a nearby post office
instead of at corporate headquarters, (ii) reduces the
processing time because the company does not have
to open the envelopes and deposit the Cheque for
collection, and (iii) shortens the availability delay
because the Cheque are typically drawn on local
banks.

In India, the lock=box system is not popular. However,
commercial banks usually provide service to their large
clients of (i) collecting the cheques from the office of
the client, and (ii) sending the high value cheques to
the clearing system on the same day. Both these
services help reducing the float of the large clients.
However, these benefits are not free. Usually, the bank
charges a fee for each cheque processed through the
system. The benefits derived from the accelearation of
receipts must exceed the incremental costs of the lock
box system, or the firm would be better without it.

When is it worthwhile to have a lock box? The answer
depends on the costs and benefits of maintaining the
lock box. Suppose that your company is thinking of
setting up a lock box. You gather the following
information:
Average number of daily payments : 50
Average size of payment : Rs. 8000
Savings in mailing and processing time : 2 days
Annual rental for the lock box : Rs. 3000
Bank charges for operating the lock box : Rs.
72,000
Interest rate : 15%
The lock box will increase your company's collected
balance by:

50 items day x Rs. 8,000 per item x 2 days saved = Rs
800,000

The annual benefit in the form of interest saving on
account of this is:

Rs 800,000 x 0.15= Rs 120,000

The annual cost of the lock box is:

Rs 3,000 (rental) + Rs 72,000 (bank charges) = Rs 75,000

Sice the interest saving exceeds the cost of the lock
box, it is advantageous to set up the lock box. More so
because your company also saves on the cost of
processing the Cheque internally.
4.1.2 Concentration Banking

A firm may open collection centres (banks) in different
parts of the country to save the postal delays. This is
known as concentration banking. Under this system,
the collection centres are opened as near to the
debtors as possible, hence reducing the time in
dispatch, collection etc. The firm may instruct the
customers to mail their payments to a regional
collection centre / bank rathen than to the Central
Office. The Cheque received by the regional collection
centre are deposited for collection into a local bank
account. Surplus funds from various local bank
accounts are transferred regularly (mostly daily) to a
concentration account at one of the company's
principal banks. For effecting the transfer several
options are available.

With the vast network of branches set up by banks
regional / local collection centres can be easily
established. To ensure that the system of collection
works according to plan, it is helpful to periodically
audit the actual transfers by the collecting banks and
see whether they are are in conformity with the
instruction given.

The concentration banking results in saving of time of
collection, and hence results in better cash
management. However, the selection of collection
centres must be based on the volume of billing /
business in a particular geographical area. It may be
noted tha the concentration banking also involve a
cost in terms of minimum cash balance required with a
bank or in the form of normal minimum cost of
maintaining a current account.

Concentration banking can be combined with the
lock box arrangement to ensure that the funds are
pooled centrally as quickly as possible.
4.1.3 Electronic Fund Transfer

The banking system has responded to the growing
need to speed up the transfer of money from one firm
to another. For example, the 'CHAPS' system in the UK
(Clearing House Automated Payments System) permits
same-day cheque clearance and CHIPS (Clearing
House Interbank Payment System), a computerised
network, enables the electronic transfer of international
dollar payments. These systems provide two benefits to
the larger firms, which use them. First, there is greter
certainity as to when money will be received and
section, they can reduce the time that money is in the
banking system.

Companies can take other action to create a
beneficial float. They could bank frequently to avoid
having cheques remaining in the accounts office for
more than a few hours. The could could also
encourage customers to pay on time, or even in
advance, of the receipt of goods and services by using
the direct debit system through which money is
automatically transferred from one account to another
on a regular basis. Many UK consumers now pay direct
debit. In return they often receive a small discount.
From the producer's viewpoint this not only reduces the
float but also avoids the onerous task of chasing late
payers. Also retailers now have terminals which permit
electronic funds transfer at the point of sale (EFTPOS) -
money taken from customers accounts electronically
using debit card.
4.2 Delaying Payments

Just as a firm can increase its net float by speeding up
collections, it can also do so by slowing down
disbursements. A common temptation is to increase
the mail time. For example, Acme Ltd. may pay its
suppliers in Cochin with Cheque sent from its Calcutta
office and its suppliers in Ludhiana with Cheque mailed
from its Chennai office. However such gimmicks
provide only a short-term benefit and finally turn out ot
be self-defeating when suppliers discover the poly and
adjust their price and credit terms appropriately.

While maximising disbursement float is a questionable
prictice, a firm can still payments. The following may be
done in this respect.

Ensure that payments are made only when they fall
due and not early. Centralise deisbursements. This helps
in consolidating funds at the head office, scheduling
payments more effectively, reducing unproductive
cash ballances at region / local offices, and investing
funds more productivity. However, care must be taken
that the goodwill and credit rating of the firm is not
affected.Payments to creditors need not be delayed
otherwise it may be difficult to secure trade credits at a
later stage.

Arrange with suppliers to set the due dates of their bills
to match with company's receipts. Synchronisation of
cash outflows with cash inflows helps a company to
get greater mileage from its cash resources.
5. ELECTRONIC DATA INTERCHANGE: WILL THE FLOAT
DISAPPEAR?
Electronic data interchange (EDI) refers to direct,
electronic exchange of information between various
parties. Financail EDI or FEDI, involves electronic transfer
of information and funds between transacting parties .
FEDI leads to elimination of paper invoices, paper
Cheque, mailing handling and so on. Under FEDI, the
seller sends the bill electronically to the buyer, the
buyer electronically authorises its bank o make
payment, and the bank transfers funds electornically to
the account of the seller at a designed bank. The net
effect is that the time requried to complete a business
transacton is shortened considerably thereby virtually
eliminating the float.

Currently one of the drawbacks of FEDI is that it is
expensive and compelx to set up the drawbacks of
FEDI is that it is India. Further, many partiesmay not
ready or willing to participate in it. HOwever wih the
advancements in technology and the growth of
Internet, e-commerce costs will fall signicantly. This will
induce more parties to participate in FEDI. As Ross
(Wererfiled and Jordan Say: " As the use of FEDI
inccreases (which it will) float management will evolve
to fucus much more on issues surrounding
computerozid information exchange and funds
transfer.
6. INTERNATIONAL CASH MANAGEMENT

Cash Management domestic firms to child's play
compared with that in large multinational corporation
operating in dozens of countries, each with its own
currency, banking system and legal structure. Unilever,
for example manufactures and sells allover the world.
To operate effectively Unilver has numerous bank
accounts so that some banking transactions can take
place near to the point of business transaction can
take place near to the point of business. Sales receipts
from America will be paid into local banks there,
likewise many operating expenses will be paid for with
funds drawn from those same banks. The problem for
Unilever is that some of those bank accounts will have
high inflows and others high outflows, so interest could
be payable on one while funds are lying idel or earning
a low rate of return in another. Therefore, as well as
taking advantage of the benefit of having local banks
carry out local transactions, large firms need to set in
place a co-ordinating system to ensure that funds are
transferred from where there is surplus to where they
are needed.

A single centralized cash management system is an
unattainable idea for these companies, althogh they
are edging towards it. For example, suppose that you
are the treasurer of a large multination company with
operations through out Europe. You could allow the
separte business to manage their own cash but that
would be costly and would almost certainly result in
each one accumalating little hoards of cash. The
solution is to set up a regional system. In this case the
company establishes a local concentration account
with a bank in each country. Then any surplus cash is
swept daily into central multicurrency accounts in
London or another European banking center. This cash
is then invested in marketable securites or used to
finance any subsidiaries that have a cash shortage.

Payments also can be made out of the regional
center. For example, to pay wages in each European
country, the company just needs to send its principal
bank a computer file with details of the payment to be
made, the bank then finds the least costly way to
transfer the for the funds to be credited on the correct
day to the employees in each country.

Most large multinationals have several banks in each
country, but the more banks they use, the less control
they have over their cash balances. So development
of regional cash management system favours banks
that can offer a worldwide branch network.