Motives for Holding Cash
John Maynard Keynes suggested three reasons for individuals to hold cash.1 Keynes labeled these motives as follows: transactions, speculative, and precautionary. Shifting the emphasis away from individuals, we can use these three categories to describe the motives for corporations to hold cash.

Motives for holding cash:

l Transactions motive: to meet payments, such as purchases, wages, taxes, and dividends, arising in the ordinary course of business.

l Speculative motive: to take advantage of temporary opportunities, such as a sudden decline in the price of a raw material.

l Precautionary motive: to maintain a safety cushion or buffer to meet unexpected cash needs. The more predictable the inflows and outflows of cash for a firm, the less cash that needs to be held for precautionary needs. Ready borrowing power to meet emergency cash drains also reduces the need for this type of cash balance.

It is important to point out that not all of the firm’s needs for cash call for holding cash balances exclusively. Indeed, a portion of these needs may be met by holding marketable securities (cash-equivalent assets) and by maintaining unused borrowing capacity (e.g., bank lines of credit). For the most part, firms do not hold cash for the purpose of speculation.
Consequently, we concentrate only on the transactions and precautionary motives of the firm, with these needs being met with balances held both in cash and in marketable securities.
Cash management involves the efficient collection, disbursement, and temporary investment of cash

. The treasurer’s department of a company is usually responsible for the firm’scash management system. A cash budget, instrumental in the process (see Chapter 7), tells us how much cash we are likely to have, when we are likely to have it, and for how long. Thus it serves as a foundation for cash forecasting and control. In addition to the cash budget, the firm needs systematic information on cash as well as some kind of control system. (See
Figure 9.1.) For a large firm, the information is usually computer based. It is necessary to obtain frequent reports, generally daily, on cash balances in each of the company’s bank accounts, on cash disbursements, on average daily balances, and on the marketable security position of the firm as well as a detailed report on changes in this position. It is also useful to have information on major anticipated cash receipts and cash disbursements. All of this information is essential if a firm is to manage its cash in an efficient manner – one that provides for safe and convenient cash availability and for reasonable investment income on temporary investments of cash. figuresh Receipts
The various collection and disbursement methods that a firm employs to improve its cash management efficiency constitute two sides of the same coin. They exercise a joint impact on the overall efficiency of cash management. The general idea is that the firm will benefit by “speeding up” cash receipts and “s-l-o-w-i-n-g d-o-w-n” cash payouts. The firm wants to speed up the collection of accounts receivable so that it can have the use of money sooner.
Conversely, it wants to pay accounts payable as late as is consistent with maintaining the firm’s credit standing with suppliers so that it can make the most use of the money it already has. Today, most companies of reasonable size use sophisticated techniques to speed up collections and tightly control disbursements. Let’s see how they do it.

l l l Collections

We consider first the acceleration of collections, which includes the steps taken by the firm from the time a product or service is sold until the customers’ checks are collected and become usable funds for the firm. A number of methods are designed to speed up this collection process by doing one or more of the following: (1) expedite preparing and mailing theinvoice; (2) accelerate the mailing of payments from customers to the firm; and (3) reduce the time during which payments received by the firm remain uncollected funds.

Collection Float. The second and third items in the preceding list collectively represent collection float, the total time between the mailing of a check by a customer and the availability of cash to the receiving firm. (See Figure 9.2.) The second item, by itself, refers to mail float,
Figurfiguree 9.1
Invoice Bill prepared by a seller of goods or services and submitted to the purchaser. It lists the items bought, prices, and terms of sale. or the time for which the check is in the mail. The third item, representing deposit float, has two aspects. The first, processing float, is the time it takes a company to process checks internally. This interval extends from the moment a check is received until the moment it is deposited with a bank for credit to the company’s account. The second aspect of deposit float is availability float; it involves the time consumed in clearing the check through the banking system. A check becomes collected funds when it is presented to the payor’s bank and is actually paid by that bank. To streamline the availability of credit, the Federal Reserve System has established a schedule specifying availability for all checks deposited with it for collection.
This schedule is based on the average time required for a check deposited with a particular
Federal Reserve Bank to be collected in a particular geographic area of the country. For business accounts, the maximum period for which credit is deferred is two days. This means that even if a check is not actually collected through the Federal Reserve System in two days, it becomes collected funds because the Federal Reserve carries the remaining float in the system.
Collection float is important to the financial manager because a company usually must wait until a check mailed by a customer finally clears the banking system before the cash becomes available to the firm. Because the name of the game is to turn mailed checks into cash more quickly, the financial manager wants to reduce collection float as much as possible. In what follows, we examine various ways to speed up the collection process to have more usable funds.

Earlier Billing. An obvious but easily overlooked way to speed up the collection of receivables is to get invoices to customers earlier. Customers have different payment habits. Some pay their bills on the discount date or the final due date (or later), and others pay immediately on receipt of an invoice. In any event, accelerated preparation and mailing of invoices will result in faster payment because of the earlier invoice receipt and resulting earlier discount and due dates. Computerized billing could be used to accomplish this. In addition, some companies find it advantageous to enclose invoices with shipped merchandise, send invoices by fax, or even request advance payment.
Billing can be eliminated entirely through the use of a preauthorized debit. A customer signs an agreement with a firm allowing the firm to automatically debit the customer’s bank account on a specified date and transfer funds from the customer’s bank to the firm’s bank.
Insurance and mortgage payments are often handled this way, as they both involve recurring payments of a fixed amount.

Preauthorized debit The transfer of funds from a payor’s bank account on a specified date to the payee’s bank account; the transfer is initiated by the payee with the payor’s advance authorization.

Lockbox

A post office box maintained by a firm’s bank that is used as a receiving point for customer remittances. Retail lockbox systems cater for the receipt and processing of low- to moderate-dollar, highvolume remittances, whereas wholesale lock-box systems are designed to handle high-dollar, low-volume remittances.

Lockbox System. The single most important tool for accelerating the collection of remittances in the United States is the

lockbox. A company rents a local post office box and authorizes its bank to pick up remittances in the box. Customers are billed with instructions to mail their remittances to the lockbox. The bank picks up the mail several times a day and deposits the checks directly into the company’s account. The checks are recorded and cleared for collection. The company receives a deposit slip and a list of payments, together with any material in the envelopes. Often, the remittance material and checks are first scanned and converted into digital images. These images can then be transmitted to the company or supplied on a CD-ROM. The benefit of this system is that checks are deposited before, rather than after, any processing and accounting work is done. In short, the lockbox arrangement eliminates processing float (the time between the receipt of remittances by the company and their deposit in the bank). Today, because of modern technology, lockbox system users also benefit from improvements in data entry efficiency and the automation of information flows. Many businesses have multiple collection locations in the form of a lockbox network. With a lockbox network, mail float and availability float are reduced by locating lockboxes close to customers’ mailing points. This type of lockbox arrangement is usually on a regional basis, with the company choosing regional banks according to its billing patterns. Before determining the regions to be used and the number of collection points, a feasibility study is made of the availability of checks that would be deposited under alternative plans. Generally, the best collection points are cities that have a high volume of air traffic, since most mail travels by air.
The main advantage of a lockbox arrangement, once again, is that checks are deposited at a bank sooner and become collected balances sooner than if they were processed by the company prior to deposit. The principal disadvantage of a lockbox arrangement is the cost.
Because the bank is providing a number of services in addition to the usual clearing of checks, it requires compensation for them. Because the cost is almost directly proportional to the number of checks deposited, lockbox arrangements are usually not profitable for the firm if the average remittance is small.
In addition to a traditional lockbox arrangement, banks also offer to provide a firm with an electronic lockbox to receive electronic payments. The banks will consolidate (if desired) the reports from both paper-based and electronic lockboxes.
The customary rule for deciding whether or not to use a lockbox system is simply to compare the added cost of the more efficient system with the marginal income that can be generated from the accelerated funds availability. If costs are less than income, the system is profitable; if not, the system is not worth implementing. The degree of profitability depends primarily on the geographic dispersion of customers, the size of the typical remittance, and the earnings rate on the released funds.

Electronic lockbox A collection service provided by a firm’s bank that receives electronic payments and accompanying remittance data and communicates this information to the company in a specified format.
Accounts receivable conversion (ARC) A process by which paper checks are converted into Automated Clearing House (ACH) debits at lockboxes or other collection sites. It reduces availability float associated with check clearing.
Automated Clearing House (ACH) A nationwide electronic funds transfer system. Payroll direct deposit and direct payment of mortgage bills are examples of typical ACH payments
Collections Improvements
As the collections landscape continues to evolve, the search for faster and cheaper collections methods has led to an interest in alternatives to physically moving original paper checks along the entire collection process. While the endgame may be to eliminate paper checks completely, the current focus in the US is on making the paper-based system more efficient and cost effective.

Math problem:

1. The Zindler Company currently has a centralized billing system. Payments are made by all customers to the central billing location. It requires, on average, four days for customers’ mailed payments to reach the central location. An additional day and a half is required to process payments before a deposit can be made. The firm has a daily average collection of $500,000. The company has recently investigated the possibility of initiating a lockbox system. It has estimated that with such a system customers’ mailed payments would reach the receipt location two and one-half days sooner. Further, the processing time could be reduced by an additional day because each lockbox bank would pick up mailed deposits twice daily.
a. Determine how much cash would be freed up (released) through the use of a lockbox system. b. Determine the annual gross dollar benefit of the lockbox system, assuming the firm could earn a 5 percent return on the released funds in Part (a) by investing in shortterm instruments. c. If the annual cost of the lockbox system will be $75,000, should such a system be initiated? 1. a. Total time savings ’ 2.5 + 1 ’ 3.5 days
Time savings ⋅ daily average collection ’ cash released
3.5 ⋅ $500,000 ’ $1,750,000
b. 5% ⋅ $1,750,000 ’ $87,500
c. Since the dollar gross benefit of the lockbox system ($87,500) exceeds the annual cost of the lockbox system ($75,000), the system should be initiated.