Chapter 2

3. Cash Management
3.1. Introduction:
Cash and marketable securities are the most liquid assets of the firm. As far as
cash is concerned it is the ready currency to which all other liquid assets can be
reduced. Whereas marketable securities are short- term, interest earning, money
market instruments that are used by the firm to obtain a return on a temporarily
idle funds. Both cash and marketable securities are held by firms to reduce the
risk of technical insolvency by providing a pool of liquid resources. Appropriate
balances can be determined by careful consideration of the motives for holding
them.
3.2. Motives for Holding Cash and Near- Cash Balances (KEYENES (liquidity
theory))
As discussed earlier cash is the most liquid form all assets. As a ready currency, it
is made available either in the bank or with the business for its operations. There
are three motives for holding cash and near cash balances.
3.2.1 Transaction Motive
Transaction motive has an objective of holding cash to meet the day-to-day
requirements like making payments to suppliers, purchase of materials, payment
of wages and salaries, and other operating expenses. Cash is also used in
standing payments like taxes, dividends and other payments. Whenever cash
inflows and cash outflows are closely matched, cash balances needed to meet the
transaction motive will be smaller.
3.2.2 Precautionary (Safety) Motive
Precautionary motive of holding cash is to meet the unexpected business
expenses. Cash is held to meet contingencies in future like emergencies. Firms
need to hold some cash in reserve for random, unforeseen fluctuations in inflows
and outflows. The purpose is to safeguard against uncertainties. Balances held to
satisfy the safety motive are invested in highly liquid marketable securities that
can immediately transfer from securities to cash.
3.2.3 Speculative Motive
Some cash balances may be held to enable the firm to take advantage of bargain
purchases that might arise; these funds are called speculative balances.
Speculative motive serves the objective of holding cash for investing in profit-
making ventures. Such opportunities are unusual within the business operations;
hence they may throw more options outside the business like, investment in the
bank, purchase of shares and bonds with an intention to resale, and purchase of
government bills.
Managing and accounting for cash is of greatest importance to the financial
health of an enterprise. Many profitable ventures fail due to cash shortages; and
many unprofitable ones survive due to availability of cash. In almost all business
organizations there are few types of transactions that do not involve cash,

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(Payment or receipt). Thus, a sound management of an enterprise’s cash
resources is utmost necessary
Cash vs Fund
Cash: any medium of exchange that is immediately negotiable, (generally
accepted)
Composition of cash
- Paper currency, coins, demand deposits, active checks
Fund: Usually, a sum of money restricted for a specified purpose.
E.g. - Change fund
- Payroll Found
- Petty Cash Fund
- Pension Fund
Items Excluded from cash
- Postage stamps, IOUs, Advances to employees,
Marketable securities, post-dated checks, NSF checks
Monitoring Cash
- Accounting for cash transactions.
- Cash reports, cash flow statements, cash budgets
- Internal control over cash
Objectives of Cash Management
The basic objectives of cash management are two, these are: -
1. To meet the cash disbursement need (payment schedule)
2. To minimize funds committed to cash balance (Minimization of Idle
cash).

3.3 The Operating Cycle

The operating cycle of a firm is defined as the amount of time that elapses from
the point at which the firm inputs materials & labor in to the production process
(i.e. begins to build inventory) to the point at which cash is collected from the
sale of the finished product that contains these production inputs. The
Operating cycle is also called the working capital cycle. The cycle is made up of
two components: the average age of inventory & the average collection period
of sales. In an equation it can be expressed as follow:
OC = AAI + ACP where: OC = Operating Cycle, AAI = Average Age of Inventory
ACP = Average Collection Period

At time zero the firm purchases raw materials, which are initially placed in the
raw materials inventory. Eventually the raw materials are used in the production
process, becoming part of the work-in-process inventory. When the work in
process is completed, the finished good is placed in the finished goods inventory
until it is sold. The total amount of times that elapse, on the average, between

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the purchases of raw materials and the ultimate sale of finished goods is the
average age of inventory.

Assume Addis Ababa Foam Plastic Manufacturing Plant, sales all its products on
credit basis. The credit terms require customers to pay within 60 days of a sale.
The firm’s computations reveal that, on average, it takes 80 days to manufacture,
and ultimately sale its product. In other words, the firm’s average age of
inventory is 80 days. Computation of the average collection period indicates that
it is taking the firm, on average, 60 days to collect its accounts receivable. Thus,
the firm’s operation cycle can be determined as below:

OC= AAI + ACP

= 80 days + 60 days = 140 days

Graphically, it can be depicted as follows:

Fig. 2.1.The operating Cycle

140 days (80+60)

Purchase Raw materials on Account Sell Finished Good Collect Accounts Receivable

AAI (80 days) ACP (60 days)

140

Average payment period (APP) (30 days)

Pay Accounts Payable

Cash outflow Cash Conversion Cycle 110 days = (140-30) Cash inflow

The operating cycle is represented by the following sequences of events:

1. Purchase of raw materials

2. Conversion of raw materials into WIP
3. Conversion of WIP into finished goods
4. Sale of finished goods, A/R
5. Conversion of A/R into cash.
3.4 The Cash Conversion Cycle

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The cash conversion cycle represents the net time elapsed between the collection
of cash receipts from product sales and the cash payments for the company’s
various resource purchases. It is computed as follows:
Cash Conversion Cycle = Operating cycle – Average Payment Period
CCC = OC – APP, but OC = AAI + ACP, so CCC = AAI + ACP – APP

Referring the previous illustrative example, the credit terms extended the firm for
raw materials purchases currently require payment within 35 days of a purchase,
and employees are paid every 15 days. The firm’s calculated weighted average
payment period for raw materials labor is 30 days, which represents the average
payment period. The cash conversion cycle of the firm is computed as follows:
CCC = OC-APP
= 140-30 = 110 days
A firm’s cash turnover (CT) can be calculated as follow.
Cash Turnover = No. of days in a year = Total annual outlays
Cash conversion cycle (CCC) Average Cash balance
By referring the same illustration above, the firm’s cash turnover is currently
3.272 times (360 days / 110 days). The higher a firm’s cash turnover, the less
cash the firm requires, Cash turnover, like inventory turnover, should be
maximized. High turnover is desirable since it reduces firm’s average cash
balance and holding costs.
Average Cash Balance = Total Annual Outlay = Total amount of budget from RM to
Collection period
Cash Turnover Cash Turnover
Example1. Over the past years, X company’s A/R have averaged 80-day sales
and inventories have averaged 60 days. The company has paid its creditors, on
average, 25 days after receiving the bill. Production is evenly spaced over the
year and the Company expects to spend $18 million during the year for materials
and supplies.
1. Compute the following:
a. Cash cycle
b. Cash turnover
c. Average cash balance
2. What is the dollar cost of tying up the fund if the company’s opportunity
cost is 20%?
Solution
1. a) cash cycle = 80+ (60- 25) = 115 days
b) Cash Turnover = 360/115 = 3.13 times
c) Average Cash Balance = 18,000,000/3.13 = $ 5,750,799
2. Dollar cost = 5750799 * .2 = $ 1,150,160
Example 2. Given the end balances of the following accounts:
Ending Balances
19X1 19X2

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Accounts Receivable $ 1,600,000$ 2,000,000
Inventory 2,000,000 3,000,000
CGS 8,200,000
Credit Sales 11,500,000
Account Payable 750,000 1,000,000
Credit Purchases 8,200,000
Determine:
1. Inventory turnover and inventory period
2. account receivables turnover and average collection period
3. Accounts payable turnover and payables period
4. Operating cycle
5. cash cycle
Solution
1. Inventory Turnover = CGS/Ave. Inventory = 8.2/2.5 = 3.3
Inventory period = 365/3.3 = 111 days
2. A/R Turnover = Credit Sales/Ave. AR = 11.5/1.8 = 6.4
Average Collection Period = 365/6.4 = 57 days
3. A/P turnover = Credit Purchase/Ave. AP = 8.2/. 875 = 9.4
Payables Period = 365/9.4 = 39 days
4. Operating Cycle = Inventory Period + Average Collection Period
111 + 57 = 168 DAYS
5. Cash Cycle = Operating Cycle – Payables Period
168 – 39 = 129 DAYS
*The operating cycle refers to the time between material arrival and cash
received from A/R
* The Operating cycle is also called the working capital cycle.
3.4.1 Cash Budget
Just as you would not purchase new furniture for your home without enough cash,
or at least a solid plan to cover a personal loan from your bank, your business
needs the same careful handling of its expenditures. All businesses, no matter
what type or size, need to properly develop a plan for their expected cash intake
and spending. This plan is commonly known as a cash budget, and it can be
prepared quarterly or annually, or most commonly, monthly.

The cash budget, or cash forecast, allows the firm to plan its short-term cash
needs. Typically, attention is given to planning surplus cash and for cash
shortages. A firm expecting a cash surplus can plan short-term investments
(marketable securities), whereas a firm expecting shortages in cash must arrange
for short-term financing. The cash budget gives the financial manager a clear
view of the timing of the cash inflows & outflows expected over a given period.

Properly preparing your cash budget will show how cash flows in and out of your
business. Also, it may then be used in planning your short-term credit needs. In

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today’s financial world, you are required by most financial institutions to prepare
cash budgets before making capital expenditures for new assets as well as for
expenditures associated with any planned expansion. The cash budget
determines your future abilities to pay debts as well as expenses. Also, a monthly
cash budget helps pinpoint estimated cash balances at the end of each month,
which may foresee short-term cash shortfalls. Typically, the cash budget is
designed to cover a one-year period, although any time period is acceptable.

Examples of Cash Budget

The following is an example of a cash budget for the 90 days provided below for
the XYZ Company: Analysis of the financial statements of the XYZ Company
shows that the accounts receivable remain at about 500,000 throughout the year;
that is, there is no seasonal fluctuation in sales. The accounts receivable turns
over six times a year, or once every 60 days. The inventory throughout the year
remains at about 800,000 and turns over 90 days. The account payable remains
at about 400,000 and turns over eight times a year, about once every 45 days.
With an account receivable collection period of 60 days and an average balance
outstanding of 500,000, it appears that 750,000 is the amount that should be
collected on the receivables in 90 days. Cash sales should amount to about
250,000 if inventory of 800,000 valued at cost turns over once in 90 days and if
the average markup is about 200,000. Therefore, if an inventory of 1,000,000 at
retail turns over once every 90 days and 750,000 flows through accounts
receivable, then approximately 250,000 must be sold on a cash basis. Cash
payments for expenses and dividends are estimated to be 150,000 and 50,000 in
the next 90 days, respectively.

a) Prepare a cash budget for next 90 days if the beginning cash balance is
320,000.
b) Compute the cash Cycle, &Operating Cycle
Answers: a) CASH BUDGET FOR 90 DAYS
Beginning cash balance 320,000 (given
beg. Balance)
Add: Estimated collection on account receivable 750,000
Estimated cash sales 250,000
1,320,000
Deduct: Estimated payments on accounts payable 800,000
(given beg. Balance)
Estimated cash expenses 150,000
Quarterly dividend payment 50,000
1,000,000
Estimated ending cash balance 320,000
b) Given
Average accounts receivable 500,000
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A/R turnover 6 = 360/60
Average Collection Period 60 days
Average Inventory 800,000
Inventory Turnover 4 = 360/90
Average Age of Inventory 90 days
Average Accounts Payable 400,000
A/Payable Turnover 8 = 360/45
Average Payment Period 45 days
Operating Cycle= Inventory Period + Average Collection Period
90 days + 60 days = 150 days
Cash Cycle = Operating Cycle - Average Payment Period
150 days - 45days = 105 days
General Format: M O N T H S
March April May…
1. Beginning cash balance 50,000 (83,000)
(11,000)
2. Total collections*** 210,000 350,000 340,000
3. Total cash available 260,000 267,000 329,000
4. Total payments*** (343,000) (278,000) (322,000)
5. Balance (83,000) (11,000) 7,000
6. Minimum cash balance 10,000 10,000
10,000
7. Cum. Borrowing to maintain
target cash balance 93,000 21,000
3000
8. Repayment - - -
9. Surplus - - -
10. Ending cash balance
Without borrowing (83,000) (11,000) 7000
***Cash receipts: Cash receipts include the total of all items from which cash
inflows result in any given month. The most common components of cash
receipts are cash sales, collections of accounts receivable, and other cash
receipts. The schedule of expected cash collections for the company is given in
the following manner: (It will contains the following items).
Schedule of projected Cash Receipts for the XYZ Company
Jan. Feb March April May Dec.
Forecast sales 100,000 200,000 400,000 300,000 300,000 200,000
Cash sales (20%) 20,000 40,000 80,000 60,000 60,000 40,000
Collection A/R:
- Lagged one month (50%) 50,000 100,000 200,000 150,000
- Lagged two months (30%) - - 30,000 60,000 120,000
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 Other cash receipts - - - 30,000 10,000
Total Receipts 20,000 90,000 210,000 350,000 340,000 . . . .
Sales forecast is merely informational. It has been provided as an aid in
calculating other sales-related items.
Cash sales: The cash sales shows for each month represent 20% of the sales
forecast for that month.
Collection of A/R: These entries represent the collection of accounts receivable
resulting from sales in earlier months.
Other cash receipts: These are cash receipts expected to result from sources
other than sales. Items such as dividends received, interest received, proceeds
from the sale of equipment, stock & Bond sale proceeds may show up here.
***Cash Disbursements. Cash disbursements include all outlays of cash in the
period covered. The most common cash disbursements are these: Cash Purchase,
Payment of A/p, Payment of cash dividends, Rent expense, Tax payment, Salary
& wages, Capital additions, etc… The schedule of expected cash disbursements
for the company is given in the following manner: (It will contains the following
items).
Schedule of projected Cash Payments for the XYZ Company
Jan. Feb. March April May.
Purchases (70% of sales) 70,000 140,000 280,000 210,000 210,000
Cash purchase (10%) 7,000 14,000 28,000 21,000 21,000
Payments of A/P:
One month (70%) - 49,000 98,000 196,000 147,000
Lagged two months (20%) - - 14,000 28,000 56,000
Cash dividends - - 20,000
Rent expense 5,000 5,000 5,000 5,000 5,000
Wages & Salary 28,000 28,000 48,000 28,000 38,000
Tax expenses - - - - 25,000
Capital additions - - 130,000 -
Interest payment - - - 10,000
Sinking fund payments - - - 20,000
Total cash disbursements 40,000 96,000 343,000 278,000 322,000
Interpreting the cash budget: The cash budget provides the firm with figures
indicating
the expected ending cash balance, which can be analyzed to determine whether
a cash shortage or surplus is expected to result in each of the months covered by
the forecast. In the above example, the firm can expect a deficit of 93,000 in
March, a deficit of 21,000 in April and s surplus of 4,000 in May.
The excess cash balance in May can be invested in marketable securities. The
deficits in March & April will have to be financed by borrowing – typically, short-
term borrowing (Note payable).
2.3. Target Cash Balance
Management’s goal should be to maintain levels of transactional cash balances
and marketable securities investments that contribute to improving the values of
the firm. If levels of cash or marketable securities are too high, the profitability of
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the firm will be lower than if more optimal balances were maintained. Firms can
use either subjective approaches or quantitative models to determine appropriate
transactional cash balances. Two quantitative models that management can use
to determine the appropriate transactional cash balances are the Baumol model
and the Miller-Orr Model.
For our discussion, we will see the following items:
* Trade-off between benefit and cost of liquidity
* Cash holding:
Benefit: Liquidity
Cost: Interest foregone

i) The Baumol Model

The Baumol Model: is a simple approach that provides for cost-efficient
transactional cash balances by determining the optimal cash conversion quantity.
It treats cash as an inventory item whose future demand for settling transactions
can be predicted with certainty. A portfolio of marketable securities acts as s
reservoir for replenishing transactional cash balance. The firm manages this cash
inventory on the basis of the cost of converting marketable securities in to cash
(the conversion cost) and the cost of holding cash rather than marketable
securities (Opportunity cost).
Conversion Cost: - Includes the fixed cost of placing and receiving an order for
cash in the amount ECQ. It includes the cost of communicating the necessity to
transfer funds to the cash account, associated paperwork costs, and the cost of
any follow-up action. The Conversion cost is stated as dollars per conversion.

Opportunity Cost: - is the interest earning per dollar given up during a specified
time period as a result of holding funds in a non-interest earning cash account
rather than having them invested in interest-earning marketable securities.

* The model is similar to EOQ in inventory management.

Basic assumptions: (steady-state assumption)
* Firm uses cash at a steady, predictable rate.
Ex. A specified sum per week, month, etc..
* Firm’s cash inflows from operations also occur at a steady, predictable
rate
* Certainty
Parameters:
T = total amount of cash needed for transaction over the entire period
(predetermined)
I = opportunity cost, (interest cost per dollar per period)
C = Amount of cash raised by selling securities or borrowing, evenly spaced, C
<=T
B = fixed cost of withdrawal or borrowing

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C/2 = average cash holding
Model Development:
* Number of withdrawals over the period = T/C, and;
Total cost of these withdrawals will be: B*T/C
* Amount of cash withdrawn, C, is spent in a steady stream. Thus, average cash
holding is C/2, therefore;
The interest cost of holding this balance will be: I*C/2
Total cost = Interest cost + Fixed cost
TC = I*C/2 + B*T/C
C* = (2B*T/I)1/2
C* = Target cash balance
Target Cash Balance Rises Less Than Proportionately With The Increase
In The Volume To Transaction,
Summary
 Model is static, disbursement over time is fixed
 Broker’s fee is assumed to be constant
 Considers only transactions motive, no “safety stock”
 Stable and predictable cash flows which is not the case in many firms.
 Seasonal and cyclical trends are not considered.
 Most applicable to salaried people

Example:
The HHT Co. has accumulated $ 100000 in excess cash. However, it is expected
that the firm will need the entire amount to over cash outflows anticipated to
occur evenly over the coming year. HHT has the funds invested in commercial
paper that pays 10% annually. The cost of transferring funds is $50 per
transaction
What is HHT ‘s target cash balance according to? Baumol model?
What is HHT ‘s total cost of cash balance? T = $ 100,000; I = 10%;
B = $ 50
C* = ((2bt)/I) 1/2 =((2*50*100000)/. 1) 1/2 = 10,000
- Interest cost = .1 (10,000/2) = $ 500
-Broker’s fee = 50(100,000/10,000) = $ 500
TOTAL COST OF CASH BALANC $1000
b. As HHT’s cash manager, you are concerned about whether the Baumol model
is on a before tax or after tax basis. HHT’s tax rate is 40%. What is HHT’s target
cash balance and total cost of cash balance on an after-tax basis?
- c* = $ 10000, (the same as above)
- TOTAL COST OF CASH BALANCE BEFORE TAX =$ 1000
LESS: tax deductible (40%) = 400
TOTAL AFTER-TAX COST OF CASH BAL. $ 600

The Miller and Orr Model

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When much uncertainty surrounds future cash flows-the firm cannot accurately
predict cash inflows and cash outflows – the Miller-Orr model, although more
difficult to apply, is generally considered more realistic and appropriate than the
Baumol model. The Miller-Orr model provides for cost efficient transactional cash
balances by determining an Upper limit (i.e. maximum amount) and a return
point for them. Cash balances are allowed to fluctuate between the upper limit
and a zero balance (Lower limit).
Assumptions:
1. Two-asset setting, cash and portfolio of liquid asset
2. Instantaneous transfer between the two assets at a given marginal cost per
transfer
3. Minimum cash level
4. Stochastic net cash flow
Two- Parameter Control-Limit Policy
h Transfer Cash
to
Marketabl
e Securities
UPPER
Cash ($) BOUND

z TARGET
Transf
er Marketable
Securi
ties to Cash
LOWER
BOUND
O Days
Fig.2.2
 Cash balance is allowed to wander freely until it reaches the lower bound,L or
the upper bound , h (The upper limit for the cash balance is 3 times the
return point or equals the lower limit plus spread.)
 When cash balance reaches the lower or the upper limit portfolio transfer will
be made to restore the balance to “z”
- Upper limit transfer from cash, (h-z) dollars.,
Cash converted to Marketable securities = Upper limit – Return point
 L is set by management depending on how much risk of a cash shortfall the
firm is willing to accept.
Parameters:
E (N)/T= expected number of transfers per day
E (M) = average daily cash balance.
Y = transaction cost per transfer
i = daily interest rate.
Expected Cost Per Day
E(c) = y E(N)/T + VE(M)
Miller and Orr expressed the above cost function in terms of decision variables, z
and h as follows.
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 Min. E (c) = yδ2/zz + v(z + zz)/3, z = (h-z)
Given L as set by management, and differentiating the function with respect to z,
and ZY and setting the derivatives equal to zero, M and O found the values of h
and z:
Z* = (3y δ2/4v) 1/3 + L OR Z* = L +(h – L)/3
H = 3z* - 2L
Where:
δ2 = variance of daily net cash flow
Average Cash Balance + (4z* - L)/3 = M*

Example
The variance of the daily net cash flows for Y Company is $ 1.44 million. The
opportunity cost of holding cash is 8% annually. The fixed cost of buying and
selling securities is $ 500 per transaction. What should be the target cash level
and upper limit if the tolerable lower limit has been established as $ 20000?
K = 8% annually
Daily interest rate (v)= (1 + i) 360 – 1 = 0.08
1 + i = (1.08)1/360
i = 0.000211 = v
z* = ((3 * 500 * 1,440,000)/(4* . 000211))1/3 + 20,000 = 34,536
h = 3z* - 2L = 3(34536) –2(20,000) = 63,608
M* = (4z* -L)/3 = ((4 * 34536) – 20000)/3 = 39,381
h = 63,608 UPPER
BOUND

Z = 34,356 TARGET

L = 20,000 LOWER
BOUND
0
Days
Z* = L + (h-L)/3 = 20000 = (63608-20000)/3= 34,536
 The target cash balance is not mid-way between h and L Cash balances will, on
average, hit the lower limit more often than the upper limit.
 Assuming L = 0 Miller and Orr found that h/3 minimizes total cost
 Z mid-way between h and L minimizes transaction cost.
 Z lower than mid-way between h and L decreases opportunity costs
 Z increases with y and the variance of daily net cash flows. Higher y makes it
more costly to hit either limit. Larger variance causes the cash balance, to hit
the limits more frequently
 Z decreases with v. The higher the interest rate, the more costly it is to hold
cash.
Steps to use the miller and Orr model
1. Set the lower control limit for the cash balance depending on the desired,
safety margin
2. Estimate the variance of daily cash net flows

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 3. Identify the interest rate and transaction costs of transfer.
4. Use the formula to compute the upper limit and the return point, z.

2.5. Cash Management Cycle

Cash management cycle is defined as “the process of identifying various cash
inflows and making them available to business needs as cash outflows,
maintaining the objective of liquidity and profitability”. Cash management is
concerned with the managing of cash efficiently. Cash is the form of money,
which is involved, with all operations of business as inflows or outflows.
Cash management can basically categorize into:
a. Cash outflow like, purchases, payment to expenses and services;
b. Cash inflows like, sales, other revenues; and
c. Cash balance held at any point of time.
A cash management cycle is used to explain the basic function of cash
management. It seeks to accomplish the objective of cost minimization by
achieving liquidity and profitability. Every business transaction resulting, as cash
inflow will increase the cash balance, while cash outflow transaction will decrease
cash balance. The following diagram explains the basic process of cash
management cycle. Cash Inflows Increases
Business Transaction

(S) Cash Balance

Cash Outflows Decreases

Fig. 2.3. Cash Management Cycle

Any firm can be successful with its cash management, when it is able to achieve
the following objectives:
1. Cash Planning: the process of estimating cash inflows and outflows to project
cash surplus or deficit for future planning period. A cash budget is used to
serve this objective.
2. Managing cash flows: The cash flows should be properly managed to avoid the
variance between planned events to actual event. Accelerating cash inflows
and decelerating cash outflows can achieve this.
3. Optimum Cash Balance: It is always essential to determine appropriate cash
balance. The cost of excess of cash holding and also the danger of cash
deficiency should be matched to determine the optimum level of cash balance.
4. Investing supplies/Borrowing deficit: The surplus cash balance over and above
the minimum balance should be always invested in the profitable ventures,
while the deficit balance should be arranged from various financing sources.
2.6.1. Managing Cash Collections and Disbursements
Financial managers have at their disposal a variety of cash management
techniques that can provide additional savings. These techniques are aimed at
minimizing the firm’s negotiated financing requirements by taking advantage of
certain imperfections in the collection and payment systems. Assuming that the
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firm has done all that it can to stimulate customers to pay promptly and to select
vendors offering the most attractive and flexible credit terms, certain techniques
can further speed collections and slow disbursements. These procedures take
advantage of the “float” existing in the collection & payment systems.

2.6.1.1. Float
In the broadest sense, float refers that have been dispatched by a payer (the firm
or individual making payment) but are not yet in a form that can be spent by the
payee (the firm or individual receiving payment). Float is the difference between
bank cash balance and book cash balance.

Float = Firm’s bank balance - Firm’s book balance

FLOAT

Disbursement Float Collection Float

 Checks written by firm  Checks received by firm
 Increase in book cash but no immediate
 Decrease in book cash but change in bank balance
no immediate change in bank

Net Float = Sum of disbursement float and collection float

Net Float = Disbursement float + Collection float
Fig. 2.4. Floats
Example: Disbursement Float
XYZ Co. currently has $ 1,000,000 on deposit with its bank. The book balance also
shows $ 1,000,000. Assume that XYZ Co. purchased materials and make
payments by writing a check for $ 10,000.
 The book balance is immediately adjusted to $ 900,000 when the check is
issued.
 The bank balance will not decrease until the check is presented to XYZ’s
bank by the supplier or his bank.
Disbursement Float = Bank Balance – Book Balance
=1,000,000 - 900,000 = 100,000
Collection “Float”
Consider the same example above, but instead of payment, the firm receives a
check from a customer for $ 200,000 and deposits the check at its bank.
 Book balance is adjusted immediately to $ 1,200,000,
 Bank balance will not increase immediately until XYZ’s bank present the
check to the customer’s bank and received the amount.
Collection Float = Bank balance – Book balance
= 1,000,000- 1,200,000 = -200,000
Net Float = 100000 –200000= -100000
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Float results an opportunity coast because the cash is not available for use during
the time checks are tied –up in the collection n process.
Example: XYZ Co. daily sales average $ 1 million. If it can speed-up collection by
one day, it frees $ 1 million which is available for investment.
Objectives:
1. Cash Collection: speed-up collections and reduce the lag between the time
customers pay their bills and the time the checks are collected.
2. Cash disbursements: slow-down payments and maximize the time between
when checks are written and when checks are presented
MAXIM: COLLECT EARLY AND PAY LATE
Accelerating collections (techniques)
1. Lockboxes, (for receivables)
a. Special post office boxes are set-up where customers mail their payments.
b. Banks collects the remittances from the boxes and enters the checks in
company bank account.
c. Bank sends details or remittances (credit memo) to the company.
d. Company processes the receivables accordingly.
2. Concentration Banking, (combined with lock boxes)
Purpose: to collect customer checks from nearby receiving location. Check
clearance is reduced.
a. Company sales offices are located nearer to customers.
b. Lock boxes are set-up near customer area.
c. Sales offices collect and process customer checks.
d. Sales offices deposit the checks into a local deposit bank account. Lock-box
receipts are also deposited in the same deposit bank account.
e. Surplus funds are transferred from the deposit bank to the concentration bank.
f. Head office cash manager uses the reservoir of cash at the concentration bank
for short term investment or some other purpose.
Delaying Disbursements, (techniques)
 Drafts, delay payments. Funds do not have to be deposited until the draft is
presented.
 Write checks on distant bank.
 Call the creditor to verify statement accuracy for large amounts.
 Mail from distant post office.

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