FREE online courses on How to Manage Cash Flow - Chapter 1 - Two Cycles-
Disbursements and Receipts
As we indicated, cash flow management consists of several
activities: Collecting accounts receivable, processing vendor payments, etc. We
need to understand the time involved with each of these activities before we can
properly plan our cash flows. Since cash consists of disbursements and receipts,
we can think of cash flow in terms of two cycles.
The total time between
when an obligation occurs and when the payment clears the bank.
Example 1 - Disbursement
Cycle Time
Specific Activity
Day
Obligation to Supplier 0
Process Invoice from
Supplier
10
Run Payables and cut
checks
25
Payment clears the bank
35
Total Cycle Time for
Disbursement = 35 days
The overall objective
within the Disbursement Cycle is to increase the cycle time; i.e. delay making
payments until they are due. We can delay payments by:
1.
Mailing checks
from locations not close to customers. This will increase the mail time or mail
float within the disbursement cycle.
2.
Disbursing
checks from a remote bank. This will increase the time required for the payment
to clear the bank; i.e. clearance float.
3.
Purchasing with
credit cards so that the time required for making payment is much longer. By
using a credit card, you will receive a bill at the end of the month payable in
30 days. This creates more processing time or processing float.
Therefore, when we
manage cash flow cycles, we try to control three types of float times:
1.
Mail Float:
Time spent in the mail.
2.
Clearance
Float: Time spent trying to clear the bank.
3.
Processing
Float: Time required to process cash flow transactions.
By increasing the float
times within disbursements, we have the use of cash for several more days. This
is a source of spontaneous financing and we can measure our cash savings.
Example 2 - Calculate
Savings from Remote Bank
Total average payroll is
$ 280,000 once every two weeks. By using a remote bank for payroll, you gain two
more days of float. How much cash is saved by using a remote bank if cash earns
12%?
$ 280,000 x (.12 / 360)
x 2 days
$ 187 savings each payroll
52 weeks per year / 2
week payroll
x 26
payroll periods
Total Annual Savings
$ 4,862
The total time between
when products or services are delivered and when payment from the customer
clears the bank.
Example 3 - Calculate
Receipt Cycle Time
Specific Activity
Day
Begin Services to
Customer 0
Issue Invoice to
Customer
30
Receive Payment
62
Payment clears the bank
66
Total Cycle Time for
Receipts = 66 days
The overall objective
within the Receipts Cycle is to decrease the cycle; i.e. shorten the time
necessary to collect and have use of cash. We can shorten the receipt cycle by:
-
Invoicing customers as quickly as possible.
- Taking
immediate action when a customer becomes delinquent.
-
Rewarding customers for making early payment by offering a discount.
-
Imposing a finance charge on customers that are seriously delinquent.
-
Evaluating the financial soundness of customers before extending credit.
-
Accepting credit cards for payment.
- Issuing
monthly statements to remind customers of amounts owed.
- Placing
collection centers near customers and/or having banks control deposits.
A lockbox system is an
example of placing control with the bank. Under a lockbox system, customers send
payments to a lockbox which is cleared daily by the bank. This can reduce
processing time for deposits and reduce clearance float. Before adopting a
lockbox system, you should weigh the costs versus the benefits.
Example 4 - Cost Benefit of Lockbox Service
It currently takes 6
days to receive and deposit payments from customers. A lockbox will cut this
time down to 4 days. Average daily collections are estimated at $ 150,000. Idle
funds earn 5% and the total annual costs for a lockbox will be $ 60,000. Should
you adopt a lockbox?
Additional Cash Flows
are $ 150,000 x 2 days
$ 300,000
Return on Cash
x
.05
Total Annual Benefit of
Lockbox
$ 45,000
Total Annual Costs of
Lockbox
$ 60,000
Net Benefit (Costs)
$ (15,000)
Based on costs vs.
benefits, a lockbox service will not provide cash savings. However, you still
may want to consider the internal control benefits of the lockbox.
