CHAPTER 30 PROVIDED an overall idea of what is involved in short-term financial management. Now it is time to get down to detail. We begin in this chapter by looking at how companies manage their holdings of cash and marketable securities. Then in the next chapter we look at the terms on which firms sell their goods and how they ensure that their customers pay promptly.
Out first task is to explain how cash is collected and paid out. In the United States small routine payments are commonly made by check. You want to ensure that when customers pay by check, you can convert these payments into usable cash in the bank quickly and cheaply. The use of checks is on the decline and large payments are almost always made electronically. You therefore need to understand how electronic payment systems work.
Our second task is to consider how much cash the firm should hold. Companies have a choice between holding cash in the bank and investing it in short-term securities. There is a trade-off here. Cash gives you a store of liquidity, which can be used to pay employees and suppliers. However, cash has the disadvantage that it does not pay interest. As we explain in the second section of this chapter, the trick is to strike a sensible balance.
In the last chapter we explained how companies raise short-term loans to tide them over a temporary cash shortage. If you are in the opposite position and have surplus cash, you need to know where you can park it to earn interest. So in the final section of this chapter we look at the menu of short-term investments that are available to the financial manager.
31.1 CASH COLLECTION AND DISBURSEMENT
The majority of small face-to-face purchases are made with coins or dollar bills. The most popular alternative in the United States for retail purchases is to pay by check. Each year individuals and firms write about 70 billion checks.
Notice that the United States is unusual in this heavy use of checks. For example, Figure 31.1 compares retail payment methods in the United States and Holland. You can see that checks are almost unknown in Holland: Most payments there are made by debit cards, direct debit, or credit transfer.1
How Checks Create Float
How does the firm’s cash balance change when it writes or deposits a check? Suppose that the United Carbon Company has $1 million on demand deposit with its bank. It now pays one of its suppliers by writing and mailing a check for $200,000. The company’s ledgers are immediately adjusted to show a cash balance of $800,000. But the company’s bank won’t learn anything about this check until it has been received by the supplier, deposited at the supplier’s bank, and finally presented to United Carbon’s bank for payment.2 During this time United Carbon’s bank continues to show
1Debit cards allow the cardholder to transfer money directly to the receiver’s bank account. With a credit transfer the payer initiates the transaction, for example by giving her bank a standing order to make a regular payment. With a direct debit the transaction is initiated by the payee and is usually processed electronically.
2Checks deposited with a bank are cleared through the Federal Reserve clearing system, through a correspondent bank, or through a clearinghouse of local banks.
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19% 2%
USA
Holland
Check
3%
27%
Check
4%
Direct debit
Direct debit
Debit card
Debit card
1%
Credit card
Credit card
52%
Credit transfer
18%
Credit transfer
74%
0%
F I G U R E 3 1 . 1
Shares of noncash retail payments in the USA and Holland in 1997. Notice the heavy use of checks in the USA.
Source: “Retail Payments in Selected Countries: A Comparative Study,” Bank for International Settlements, Basel, 1999.
in its ledger that the company has a balance of $1 million. The company obtains the benefit of an extra $200,000 in the bank while the check is clearing. This sum is often called payment, or disbursement float.
Company's ledger balance
+
Payment float
$800,000
$200,000
equals
Bank's ledger balance $1,000,000
Float sounds like a marvelous invention, but unfortunately it can also work in reverse. Suppose that in addition to paying its supplier, United Carbon receives a check for $100,000 from a customer. It deposits the check, and both the company and the bank increase the ledger balance by $100,000:
Company's ledger balance
+
Payment float
$900,000
$200,000
equals
Bank's ledger balance $1,100,000
But this money isn’t available to the company immediately. The bank doesn’t actually have the money in hand until it has sent the check to, and received payment from, the customer’s bank. Since the bank has to wait, it makes United Carbon wait too—usually one or two business days. In the meantime, the bank will show that United Carbon has an available balance of $1 million and an availability float of $100,000:
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Company's ledger balance
+
Payment float
$900,000
$200,000
equals
Bank's ledger balance
$1,100,000
equals
Available balance
+
Availability float
$1,000,000
$100,000
Notice that the company gains as a result of the payment float and loses as a result of the availability float. The difference is often termed the net float. In our example, the net float is $100,000. The company’s available balance is therefore $100,000 greater than the balance shown in its ledger.
As financial manager you are concerned with the available balance, not with the company’s ledger balance. If you know that it is going to be a week or two before some of your checks are presented for payment, you may be able to get by on a smaller cash balance. This game is often called playing the float.
You can increase your available cash balance by increasing your net float. This means that you want to ensure that checks paid in by customers are cleared rapidly and those paid to suppliers are cleared slowly. Perhaps this may sound like rather small beer, but think what it can mean to a company like Ford. Ford’s daily sales average about $450 million. Therefore if it can speed up the collection process by one day, it frees $450 million, which is available for investment or payment to Ford’s stockholders.
Some financial managers have become overenthusiastic in managing the float. In 1985, the brokerage firm E. F. Hutton pleaded guilty to 2,000 separate counts of mail and wire fraud. Hutton admitted that it had created nearly $1 billion of float by shuffling funds between its branches, and through various accounts at different banks. These activities cost the company a $2 million fine and its agreement to repay the banks any losses they may have incurred.
Managing Float
Float is the child of delay. Actually there are several kinds of delay, and so people in the cash management business refer to several kinds of float. Figure 31.2 summarizes.
Of course the delays that help the payer hurt the recipient. Recipients try to speed up collections. Payers try to slow down disbursements.
Speeding Up Collections
Many companies use concentration banking to speed up collections. In this case customers in a particular area make payment to a local branch office rather than to company headquarters. The local branch office then deposits the checks into a
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F I G U R E 3 1 . 2
Delays create float. Each heavy arrow represents a source of delay. Recipients try to reduce delay to get available cash sooner. Payers prefer delay because they can use their cash longer.
Note: The delays causing availability float and presentation float are equal on average but can differ from case to case.
Recipient sees delays as collection float
Check mailed
Mail float
Check received
Processing float
Payer sees
same delays
as payment
Check deposited
float
Availability
Presentation
float
float
Cash
Check
available
charged to
to recipient
payer's account
local bank account. Surplus funds are transferred to a concentration account at one of the company’s principal banks.
Concentration banking reduces float in two ways. First, because the branch office is nearer to the customer, mailing time is reduced. Second, since the customer’s check is likely to be drawn on a local bank, the time taken to clear the check is also reduced. Concentration banking brings many small balances together in one large, central balance, which can then be invested in interest-paying assets through a single transaction. For example, when Amoco streamlined its U.S. bank accounts in 1995, it was able to reduce its daily bank balances in non-interest-bearing accounts by almost 80 percent.3
Often concentration banking is combined with a lock-box system. In a lock-box system, you pay the local bank to take on the administrative chores. The system works as follows. The company rents a locked post office box in each principal region. All customers within a region are instructed to send their payments to the post office box. The local bank, as agent for the company, empties the box at regular intervals and deposits the checks in the company’s local account. Surplus funds are transferred periodically to one of the company’s principal banks.
3“Amoco Streamlines Treasury Operations,” The Citibank Globe, November/December 1998.
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How many collection points do you need if you use a lock-box system or concentration banking? The answer depends on where your customers are and on the speed of the U.S. mail. For example, suppose that you are thinking of opening a lock box. The local bank shows you a map of mail delivery times. From that and knowledge of your customers’ locations, you come up with the following data:
• Average number of daily payments to lock box:
150
• Average size of payment:
$1,200
• Rate of interest per day:
.02 percent
•
Saving in mailing time:
1.2 days
•
Saving in processing time:
.8 day
On this basis, the lock box would increase your collected balance by
150 items per day $1,200 per item (1.2 .8) days saved $360,000
Invested at .02 percent per day, $360,000 gives a daily return of
.0002 $360,000 $72
The bank’s charge for operating the lock-box system depends on the number of checks processed. Suppose that the bank charges $.26 per check. That works out to 150 .26 $39 per day. You are ahead by $72 39 $33 per day, plus whatever your firm saves from not having to process the checks itself.
Our example assumes that the company has only two choices. It can do nothing, or it can operate the lock box. But maybe there is some other lock-box location, or some mixture of locations, that would be still more effective. Of course, you can always find this out by working through all possible combinations, but it may be simpler to solve the problem by linear programming. Many banks offer linear programming models to solve the problem of locating lock boxes.4
Controlling Disbursements
Speeding up collections is not the only way to increase the net float. You can also do so by slowing down disbursements. One tempting strategy is to increase mail time. For example, United Carbon could pay its New York suppliers with checks mailed from Nome, Alaska, and its Los Angeles suppliers with checks mailed from Vienna, Maine.
But on second thought you will realize that such post office tricks are unlikely to give more than a short-run payoff. Suppose you have promised to pay a New York supplier on February 29. Does it matter whether you mail the check from Alaska on the 26th or from New York on the 28th? Of course, you could use a remote mailing address as an excuse for paying late, but that’s a trick easily seen through. If you have to pay late, you may as well mail late.5
There are effective ways of increasing presentation float, however. For example, suppose that United Carbon pays its suppliers with checks written on a New York City bank. From the time that the check has been deposited by the supplier, there
4See, for example, A. Kraus, C. Janssen, and A. McAdams, “The Lock-Box Location Problem,” Journal of Bank Research 1 (Autumn 1970), pp. 50–58.
5Since the tax authorities look at the date of the postmark rather than the date of receipt, companies have been tempted to use a remote mailing address to pay their tax bills. But the tax authorities have reacted by demanding that large tax bills be paid by electronic transfer.
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will be an average lapse of little more than a day before it is presented to United Carbon’s bank for payment. The alternative is that United Carbon pays its suppliers with checks mailed to arrive on time but written on a bank in Helena, Montana; Midland, Texas; or Wilmington, Delaware. In these cases, it may take three or four days before each check is presented for payment. United Carbon, therefore, gains several days of additional float.6
Some firms even maintain disbursement accounts in different parts of the country. The computer looks up each supplier’s zip code and automatically produces a check on the most distant bank.
The suppliers won’t object to these machinations because the Federal Reserve guarantees a maximum clearing time of two days on all checks cleared through its system. The Federal Reserve, however, does object and has been trying to prevent remote disbursement.
A New York City bank receives several check deliveries each day from the Federal Reserve system as well as checks that come directly from other banks or through the local clearinghouse. Thus, if United Carbon uses a New York City bank for paying its suppliers, it will not know at the beginning of the day how many checks will be presented for payment. It must either keep a large cash balance to cover contingencies or be prepared to borrow. However, instead of having a disbursement account with a bank in New York, United Carbon could open a zerobalance account with a regional bank that receives almost all check deliveries in the form of a single, early-morning delivery from the Federal Reserve. Therefore, it can let the cash manager at United Carbon know early in the day exactly how much money will be paid out that day. The cash manager then arranges for this sum to be transferred from the company’s concentration account to the disbursement account. Thus by the end of the day (and at the start of the next day), United Carbon has a zero balance in the disbursement account.
United Carbon’s regional bank account has two advantages. First, by choosing a remote location, the company has gained several days of float. Second, because the bank can forecast early in the day how much money will be paid out, United Carbon does not need to keep extra cash in the account to cover contingencies.
The Finance in the News box describes how one Canadian company was able to reduce its cash needs by concentrating its cash holdings and using zerobalance accounts.
Electronic Funds Transfer
Throughout the world the use of checks is on the decline. For consumers they are being replaced by credit or debit cards. In the case of companies, payments are increasingly made electronically.7 Electronic payments are relatively few in number but they account for the majority of transactions by value. Electronic payment systems may be of two kinds—a gross settlement system or a net settlement system. With gross settlement each payment is settled individually; with net settlement all payment instructions are accumulated and then at the end of the day any imbalances are settled.
6Remote disbursement accounts are described in I. Ross, “The Race Is to the Slow Payer,” Fortune, April 18, 1983, pp. 75–80.
7Consumers also may receive and pay bills electronically via their personal computer. Currently Electronic Bill Presentment and Payment (EBPP) accounts for only a small proportion of payments but it is forecasted to grow rapidly.
HOW LAIDLAW RESTRUCTURED ITS CASH MANAGEMENT
The Canadian company, Laidlaw Inc., has more than 4,000 facilities throughout America, operating school bus services, ambulance services, and Greyhound coaches. During the 1990s the company expanded rapidly through acquisition, and its number of banking relationships multiplied until it had 1,000 separate bank accounts with more than 200 different banks. The head office had no way of knowing how much cash was stashed away in these accounts until the end of each quarter, when it was able to construct a consolidated balance sheet.
To economize on the use of cash, Laidlaw’s financial manager sought to cut the company’s aver-
age float from five days to two. At the same time management decided to consolidate cash management at five key banks. This enabled cash to be zero-balanced to a single account for each division and swept daily to Laidlaw’s disbursement bank. Because the head office could obtain daily reports of the company’s cash position, cash forecasting was improved and the company could reduce its cash needs still further.
Source: Cash management at Laidlaw is described in G. Mann and S. Hutchison, “Driving Down Working Capital: Laidlaw’s Story,”
Canadian Treasurer Magazine, August/September 1999.
In the United States there are two systems for making large-value electronic payments—Fedwire (a gross system) and CHIPS (a net system). Fedwire is operated by the Federal Reserve system and connects over 10,000 financial institutions in the United States to the Fed and thereby to each other. Suppose Bank A instructs the Fed to transfer $1 million from its account with the Fed to the account of Bank B. Bank A’s account is debited immediately and Bank B’s account is credited at the same time. Fedwire is therefore an example of a real-time gross settlement (RTGS) system. Most developed countries now operate RTGS systems for large-value payments.
Real-time gross settlement suffers from a potential problem. If Bank A needs to pay Bank B, B needs to pay C, and C needs to pay A, there is a risk that the system could gridlock unless each bank kept a large reserve with the Fed. (A might not be able to pay B until it has been paid by C, C can’t pay A until paid by B, and B in turn is awaiting payment by A.) To oil the wheels, therefore, the Fed takes on the credit risk by paying the receiving bank even if there are insufficient funds in the account of the payer. Since each payment is final and guaranteed by the Fed, each receiving bank can be sure that it has the money and can give its customer immediate access to the funds.
Cross-border high-value payments in dollars are handled by CHIPS, which is a privately owned system connecting 115 large domestic and foreign banks. CHIPS accumulates payment instructions throughout the day, and at the end of the day each bank settles up the net payment using Fedwire. This means that, if the bank receiving payments makes the funds available to its customers during the day, it would be at risk if the paying bank goes belly up during the day. Banks control this risk by imposing intraday credit limits on their exposure to each other.
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Fedwire and CHIPS provide same-day settlement and are used to make highvalue payments. Bulk payments such as wages, dividends, and payments to suppliers generally travel through the Automated Clearinghouse (ACH) system and take two to three days. In this case the company simply needs to provide a computer file of instructions to its bank, which then debits the corporation’s account and forwards the payments to the ACH system. The ACH system is the largest payment system in the United States and in 1999 handled 6.2 billion payments with a value of $19 trillion.
For companies that are “wired” to their banks, customers, and suppliers, these electronic payment systems have at least three advantages:
•Record keeping and routine transactions are easy to automate when money moves electronically. Campbell Soup’s Treasury Management Department discovered that it could handle cash management, short-term borrowing and
lending, and bank relationships with a total staff of seven. The company’s domestic cash flow was about $5 billion.8
•The marginal cost of transactions is very low. For example, it costs less than $10 to transfer huge sums of money using Fedwire and only a few cents to make an ACH transfer.
•Float is drastically reduced. Wire transfers generate no float at all. This can result in substantial savings. For example, cash managers at Occidental Petroleum found that one plant was paying out about $8 million per month three to five days early to avoid any risk of late fees if checks were delayed in the mail. The
solution was obvious: The plant’s managers switched to paying large bills electronically; that way they could ensure they arrived exactly on time.9
International Cash Management
Cash management in domestic firms is child’s play compared with that in large multinational corporations operating in dozens of countries, each with its own currency, banking system, and legal structure.
A single, centralized cash management system is an unattainable ideal for these companies, although they are edging toward it. For example, suppose that you are the treasurer of a large multinational company with operations throughout Europe. You could allow the separate businesses to manage their own cash but that would be costly and would almost certainly result in each one accumulating 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 securities 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 payments to be made. The bank then finds the least costly way to transfer the cash from the company’s central accounts and arranges for the funds to be credited on the correct day to the employees in each country.
8J. D. Moss, “Campbell Soup’s Cutting-Edge Cash Management,” Financial Executive 8 (September/ October 1992), pp. 39–42.
9R. J. Pisapia, “The Cash Manager’s Expanding Role: Working Capital,” Journal of Cash Management 10 (November/December 1990), pp. 11–14.
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Companies that maintain separate balances in each country are liable to find that they have a cash surplus in one country and a shortage in another. In this case the company could lend the surplus and borrow the deficit. However, that is likely to be costly, since banks need to charge a higher rate to borrowers than they pay to lenders. One alternative is to convert the surplus cash pool into the currency which is in short supply, but the simpler solution is to arrange for the bank to pool all your cash surpluses and shortages. In this case no money is transferred between accounts. Instead, the bank just adds together the credit and debit balances and pays you interest at its lending rate on the net surplus.
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 systems favors banks that can offer a worldwide branch network. These banks also can afford to invest the several billion dollars that are needed to set up computer systems for handling cash payments and receipts in many different countries.
Paying for Bank Services
Much of the work of cash management—processing checks, transferring funds, running lock boxes, helping keep track of the company’s accounts—is done by banks. And banks provide many other services not so directly linked to cash management, such as handling payments and receipts in foreign currency or acting as custodian for securities.10
All these services have to be paid for. Usually payment is in the form of a monthly fee, but banks may agree to waive the fee as long as the firm maintains a minimum average balance in an interest-free deposit. Banks are prepared to do this, because, after setting aside a portion of the money in a reserve account with the Fed, they can relend the money to earn interest. Demand deposits earmarked to pay for bank services are termed compensating balances. They used to be a very common way to pay for bank services, but there has been a steady trend away from using compensating balances and toward direct fees.
31.2 HOW MUCH CASH SHOULD THE FIRM HOLD?
Cash pays no interest. So why do individuals and corporations hold billions of dollars in cash and demand deposits? Why, for example, don’t you take all your cash and invest it in interest-bearing securities? The answer of course is that cash gives you more liquidity than securities. You can use it to buy things. It is hard enough getting New York cab drivers to give you change for a $20 bill, but try asking them to split a Treasury bill.
In equilibrium all assets in the same risk class are priced to give the same expected marginal benefit. The benefit from holding Treasury bills is the interest that you receive; the benefit from holding cash is that it gives you a convenient store of liquidity. In equilibrium the marginal value of this liquidity is equal to the marginal value of the interest on Treasury bills. This is just another way of saying that Treasury bills are investments with zero net present value; they are fair value relative to cash.
10Of course, banks also lend money or give firms the option to borrow under a line of credit. See Section 30.6.
