CASH MANAGEMENT

SYSTEM
INTRODUCTION
 Cash is the lifeblood of a business firm, it is
needed to acquire supplies, resources,
equipment and other assets used in
generating the products and services
provided by the firm.
 It is also needed to pay salaries and wages to

workers, taxes to government, interest and

principals to creditors, dividends to
shareholders etc.
Motives for holding cash and
other marketable securities
 Cash for transactions
 Cash and near cash assets as hedges
 Temporary Investments
Factors Determining the Cash
Balance
 The factors that determine the costs and
benefits holding liquid assets are listed below
1) Synchronization of the cash flows
2) Short costs
3) Excess cash balance costs
4) Procurement and Management costs
5) Compensating Balances
6) Uncertainty and Cash Management
Synchronization of the cash flows
 First select a planning horizon
 Forecasting the cash inflows
 Forecasting the cash outflows
 It pinpoints those months in which the firm

will have excess cash to invest temporarily in

marketable securities and those months in
which the firm will have a cash shortfall
Short Costs
 Every shortfall incurs costs, depending on the
severity duration and frequency of the
shortfall a mode of average. Expenses
incurred as a result of a shortfall are called
short costs.
 Most common short cost is transaction costs

associated with raising cash.

Excess Cash Balance Costs
 The most significant cost associated with
maintaining a cash balance is the opportunity
cost of holding the cash which may be
represented by the companies required rate
of return.
Procurement and Management
costs
 In addition to the shortfall and excess
balance costs there are costs associated with
establishing and operating a cash
management staff and activities.
Compensating balances
 Businesses depend on banks for many
services. Some of the services paid by direct
fees others are paid indirectly by maintaining
a compensating balance in bank.
Uncertainty and cash management
 Since cash inflow and cash outflow can never
be synchronized and predicted with complete
accuracy the financial manager has to
recognize the impact of uncertainty on cash
management strategy.
 To reduce the potential impact of uncertainty
on cash management , the financial manager
can have borrowing agreement with the bank.
This is called overdraft previledge and the
company will have to pay a larger rate on the
portion to be drawn upon.
The Cash System
 The cash system of a firm is the mechanism
that provides the linkage between the cash
flows.
 The external element of the cash system

include a collection system for getting cash

into the firm and disbursement system for
paying the suppliers and other receiver s of
cash.
Managing the cash flow
 The financial manager must make certain that
the investment in cash is efficiently used.
 In order to minimize leaks manager should

establish some short of control system.

 Embezzlement is greatly reduced if receipt of

such fund is assigned to different employees.

 Cash management involves at least two

different functions
1) Ways in which speed up cash inflows
2) Ways in which to slow disbursement.
Objestive of a collection
system
 The primary objective of a collection system
is to receive value from the buyer as quickly as
possible.
 The second objective is to receive and process
information associated with the payment.
 The third reason is the relationship of the firm
has with those making payments
 Keeping al this things in mind objective
function may be stated in more formal terms
as follows-
Cont….
Minimize the cost of collection float
- Value of payment information
- value of the relationship with payors.
+ collection system costs
+ cost of losses through theft/ fraud
Cost of collection float
 One of the most important factors in this
objective function is the value of the
collection float. For example, assume a
company is losing approximately 6 calendar
days of interest on Rs. 20,00,000 each week.
The annual cost of this float at 12%
opportunity cost is
Rs 20,00,000 X 6 days x .12/365x52
= Rs. 2,05,150 per year.
Value of payment
information
 Information regarding the payment is vital for
the company. It is important for the company
to know which customers costs are being
covered by the weekly payment so that billing
can be accurate.
Value of relationship with payor
 The relationship between the firm and the
customer may be harmed if there is any
problem in posting payment information to a
customers account
Collection system Costs
 A collection system incurs costs in processing
payments. Some of these costs are direct
such as bank charge while other costs were
indirect such as administrative costs.
Cost of losses from fraud and
theft
 In systems that collects payment through
cash there is a potential for loss due to theft
and fraud. The objective should be to
minimise a collection float but also to deal
with security problems.
Design of a collective system
 A collection system moves payments from payors to
available deposits in the banking system as efficiently
as possible.
 There are five major elements in this system

1) The number of collection points.

2) Location of the collection points

3) Internal or external operations of the collection

points
4) Assignment of individual payors to collection point

5) Capture and movement of information about the

payment to appropriate users in the system
Collection float
 The term collection float refers to the total
time lag between the mailing of the payment
by the payor and the availability of the cash
in the bank.
 There are three elements in the collection

float
1) Mail float
2) Processing float
3) Availability float
Cont…..
 The last two elements of the collection float
were referred as deposit float. That is the
difference between the cash recorded as a
deposit in company's books and the increase
in the available balance at the bank.
Float Measurement
 The measurement of a float is function both
of the time lag and the amount involved. It is
calculated by multiplying the time lag in days
by the amount being delayed. It can be
measured by
1) Individual item float
2) Average daily float
EXAMPLE
 A firm receives three items each month.
Calculate individual item float and average
daily float.
 Item 1- Rs 45,00,000 delayed by 3 days
 Item 2- Rs 30,00,000 delayed by 4 days
 Item 3 – Rs 25,00,000 delayed by 7 days
Cost of float
 The cost of float represents the opportunity
costs because the cash is unavailable for use
during the time payments are tied up in
collection.
 The cost of the float is determined by

multiplying the average daily float by the

opportunity cost.
Optimizing the collection system
 To optimise mailed payment collection three
elements of collection system design are
important.
1) Reducing float costs
2) Reducing operating costs
3) Reducing the administrative costs.
The attempt to optimize a system usually
involves a tradeoff between these three cost
elements, a reduction in one type of cost is
available only with increase in another.
Cont.
 Reducing mail float
 Reducing processing float
 Reducing availability float
Types Of Collection Systems
 Over the counter collections
 Mail payments collection system
 Other collection system
Over the counter collecton
 Over the counter collection system is where
the payment is received in a face to face
meeting with the customer.
 The basic component of an over the counter

collection system include field unit, a local

deposit bank and a central information
system.
System Design
 Field office location
 Type of payment accepted
 Selection of deposit banks
 Bank compensation
 Information gathering
Mailed payment collection system
 For many companies payments, almost
always cheques are mailed by the customer
in response to an invoice. A mailed payments
system contains all three components of
collection float: mail float, processing float
and availability float.
Basic Components
 The mailed payment collection system
consists of collection centers, deposit banks
and an information system.
System Design
 Number of collection points
 Collection point location
 In house versus external operations
 Payor assignment
 Type of payor
Other collection system
 Several other types of collection system are
used. Many of them used advanced and
electronic s communication system.
 Preauthorized Payments
 Lockbox systems
Preauthorized payments
 Preauthorized cheques and preauthorized
Drafts are sometimes used when the payment
amount and range are specified in advance. It
eliminate mail float, reduce processing and
availability float.
 Electronic collection procedure
Lock Box System
 A “ lock box” is a post office box number to
which some or all of the firms customers are
instructed to send their cheques. The firm
grants permission to its bank to take these
cheques and immediately start them in the
clearing process.
 It can lead to some misrouting of some

documents .
 Their proper use can reduce all types of

floatation on incoming cheques.

Cont..
 The important decision in the formulation of
a lockbox strategy are
 Where the firm should locate the lockboxes
 To which lockbox should each of the firms

customer send their chieques?

Cont..
 To solve the lock box location problem the
firm must collect four typed of data
1) The mail and clearing times for sending
cheques from each part of the firms
geographic sales area to each possible
lockbox
2) The total amount of daily cheques and total
funds
3) The required rate return
4) The variable and fixed cost of each lock box
Some Warnings about lockbox
location decision
 Determining customer zone
 Obtaining bank cost data
 Obtaining a representative sample of cheques

volume and origination

 The costing of the float
 Interaction with the availability of borrowing

capacity
Cash concentration
strategies
 Once the remittance from the firms
customers have been received and cleared,
the resulting cash balances are available in
the firms lockbox banks. It is useful for the
firm to collect these balances from the banks
into a central bank account. The process of
collecting cash is called cash concentration.
Advantages of cash concentration
 The cash collection process results in a
larger pool of funds. It makes the temporary
interest earning investment more economical
because it reduces the transaction costs on
investment.
 With all the cash in one place keeping track of

the cash is simplified.

Functions
 A concentration bank performs three main
tasks
1) Receive deposits from banks in the firms
collection system
2) Transfer funds to the firms disbursement
banks
3) Serve as the focal point for credit and
investment transactions.
Cont..
 To perform the last function the cash in the
concentration bank is monitored. When the
level becomes too high , the extra cash is
moved into short term investments or used to
pay of credit lines.
 When the level dips too low needed cash is

supplied by the sale of short term

investments from a draw on short term
borrowing sources. The process is called
aggregate cash position management.
Objective function of cash
concentration
 Minimize
opportunity costs of excess balances
+ transaction costs
 Interest on dual balances

+ opportunity costs
+ control costs
The dual balance factor has a negative sign
because as the dual balance increases costs
are reduced
Reducing information, processing
and clearing delays
 Information and processing delays
 Anticipation- moving transfer initiation
forward
1) Ledger anticipation

2) Deposit anticipation
 faster transfer mechanisms
 Reducing transfer costs
 Balance averaging
 Reducing administrative costs
 Improving concentration control
Disbursement Systems
 Disbursement systems include the banks and
delivery mechanisms
 Disbursement falls under more direct control

of headquarters and generally involves fewer

banks.
 There can be the problem of intentionally

delayed payments and strained vendor

relationships.
Objective function
 The objective function of a disbursement
system is-
Miximise
+ value of disbursement float
 Loss of discounts for early payment

 The cost of excess balances in disbursement

accounts
 Transaction costs

 Administrative , information and control costs

+ the value from dual balances.

Value of disbursement float
 All other things equal , a firm would rather
pay later than sooner. There is value in
delayed payments because the firm can either
invest cash for a longer time or put off the
cost of obtaining cash from lenders or
investors
Components of payment
float
 The entire timeline is defined as payment
float while disbursement float is measured
from the time the payor mails the cheque to
the time of presentment at the payors bank.
 Disbursement float consists of

1) Mail float
2) Processing float
3) Presentation or clearing float
Other important facts to be
considered
 Mail float issues
 Missed discounts
 Excess balances
 Transaction costs
 Dual balances
 Payee relationships
 Administrative costs
 Control costs
Types of disbursement Decisions
 It is convenient to think of disbursement
decisions in two categories: Strategic and
tactical.
 Strategic decisions are those that have long

range consequences and generally more

difficult to change on short notice. Tactical
decisions are the day to day operating
decisions.
Strategic Decisions
 Selection of disbursement bank set
 Selection of concentration bank
 Disbursement payment and account funding

mechanism
 Level of authority for authorizing

disbursements
 Policies for determining when and how much

to pay
Tactical decisions
 Disbursement authorization
 Funding amount and timing
 Payment preparation and release
 Drawee bank selection
 Mail point
Centralized versus decentralized
disbursing.
 The disbursement control lies between
completely centralised and completely
decentralised decision making.
 Strategic decisions tend to be centralised

where as tactical decisions tend to be more

decentralised.
 We can classify them into two forms mainly
 Primarily decentralised
 Primarily decentralised
Disbursement tools
 Commercial banks and others providers offer
a number of tools and assist managers in
designing efficient disbursement systems.
 Zero balance account
 Controlled disbursing.
Investment in marketable
securities
 General selection criteria-
1) Safety
2) Maturity
3) Marketability
Types of marketable
securities
 The securities most commonly held as part
as part of marketable securities portfolio are
divided into two groups.
 Government issues
 Non governmental issues
Problem1
 S.N Company currently maintains a
centralised billing system at its home office
to handle average daily collection of Rs.
4,50,000. The total time for mailing,
processing and clearing has been estimated
at 4 days.
 If the companies opportunity cost on short

term fund is 15%, how much this time lag of

4 days is costing the company?
Cont..
 If the management had designed a system of
lock box with regional banks that would have
reduced the float by 11/2 days and home
office credit department cost by 52,000
annually what is the largest total amount of
required compensating balance that the firm
should be willing to accept with the lockbox
system?
Problem-2
 A firm is currently disbursing from its
concentration bank at a cost of Rs. 25 per month
for account maintenance and Re .10 per cheque
processed. The controlled disbursement bank will
charge Rs. 75 per month for account maintenance
and Re .15 per cheque processed. The controlled
disbursement account will add ½ day float to the
disbursements. The company issues 100 cheques
of average face value Rs 2500 per day. The
treasurer maintains an overnight portfolio of about
10,00,000 on which she currently earns about 6%
per annum.
Cont..
 she estimates that she could earn an
additional 25 basis points on the investments
if she could invest earlier in the day. Transfer
to the controlled disbursement account could
be done at a cost of Re 1 per transfer.
Calculate the annual net benefit or cost of
using the controlled disbursement account
instead of the current system.
Problem 3
 The XYZ company currently makes payment by
cheque. The ABC company a supplier has
requested that XYZ allows ABC to debit their
account 10 days after the invoice date. XYZ
currently pays ABC with a cheque mailed 30 days
after the invoice date. It takes an average of 5 days
for the cheque to clear through XYZ account. The
average payment to ABC is Rs 500. it costs XYZ an
average of RS 10 to process the invoice through the
account payable dept and to issue a cheque. These
cost will be eliminated with this new proposal the
opportunity cost is 10% .
cont
 Should XYZ accept ABC’s offer?
 XYZ received a similar offer from TNK

company. Payment to TNK company average

Rs. 5000. All other information is unchanged
from ABC. Should they accept the offer from
TNK?