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Chapter13: Working capital management

13.3 Managing the collection and disbursement of cash

A firm’s cash balance as reported in its financial statements (its book or ledger balance) is not the same thing as the balance shown in its bank account (its available or collected balance). The difference between available balance and book balance is called float the difference between book cash and bank cash, representing the net effect of cheques in the process of clearing, and it represents the net effect of cheques in the process of clearing.

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Disbursement float
Cheques written by the firm generate disbursement float, causing a decrease in its book balance but no change in its available balance. For example, suppose All Beads Ltd (ABL) currently has $100 000 on deposit with its bank. On 8 June, it buys some raw materials and pays with a cheque for $100 000. The company’s book balance is immediately reduced by $100 000 as a result.

   ABL’s bank, however, will not find out about this cheque until it is presented to ABL’s bank for payment on, say, 14 June or it could be a far longer time. Until the cheque is presented, the firm’s available balance is greater than its book balance by $100 000. In other words, before 8 June, ABL has a zero float:

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   During this period that the cheque is clearing (moving through the banking system), ABL has a balance with the bank of $100 000.

Managing the float
With the increase in credit card activity and electronic settlement of accounts, the bank-clearing time for payments is being reduced. Within the states the banks are locked into a single clearing system so that cheques are cleared within a day. Interstate transfers can take two days because of the need to transfer information to different clearing systems. While cheques are now cleared quickly some banks still limit customers as to fund availability by arbitrarily placing a two- or three-day clearance time. This is in case there is a problem with the funds getting cleared, (that is, the cheque bouncing!). As a result many firms are minimising cheque use and moving to a system of direct transfer or payment. Under this system transfers are made direct to suppliers’ bank accounts and receipts are transferred direct into the bank account of the firm. Prior to or at the time of the transaction, bank account details, such as account number and bank identification, are exchanged to facilitate the closure of the transaction. Transfers may cover all nature of expenditure such as wages, rent, purchases, repairs, computer and office supplies, travel and even capital purchases. As well as the time factor other incentives for direct transfers include convenience and the lower cost involved.

   The amount of time that cash spends in the cash collection process depends on where the customers of the firm and the banks are located and how efficient the firm is at collecting its debts. The first element is beyond the control of the firm; however, the second is well within the firm’s control. One method the firm may use to collect its accounts receivable is to factor the accounts.

Factoringthe process whereby a firm sells its accounts receivable occurs when the firm sells its accounts receivable. The decision to enter into a factoring arrangement may be taken as a conscious decision to sell off existing debtors or the arrangement may be created when the sale is made. In the latter situation the sale is made through credit card facilities, such as Visa. When a credit card facility is used the organisation financing the facility assumes responsibility for the debt so that the firm has immediately factored its accounts receivable. Factoring arrangements may be distinguished on the basis of whether they are ‘notification’ or ‘non-notification’ agreements.

Notification agreements
In this situation customers of the firms that make the sales are aware that the factoring arrangement exists. As is the case with Visa, the statements of account bear the name of the factoring organisation and payments are made directly to that company. The accounts receivable ledger is maintained by the factoring company. Usually the factoring company assumes all the bad-debt risk so that the agreements are known as credit-risk agreements or non-recourse agreements.

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Non-notification agreements
In this situation customers of the selling company are not notified of the agreement. The statements of account bear the name of the selling company, and customers either pay the selling company, which then passes the payment on to the factoring company, or the payments are sent to a post office box rented by the factoring company. The accounts receivable ledger may be maintained by the selling company; however, the factoring company may perform this service for a higher fee. The selling company would receive immediate payment for only a specified percentage of the accounts receivable. This is frequently between 60 and 80 per cent. The residual is paid, less the factoring fee, once full settlement is received from the customer. These loans are usually full recourse. In other words if the amount of bad debts are above the 20 to 40 per cent buffer, the lending institution will try and recover the outstanding money from the selling company.

Cost of factoring
The factoring company charges a flat percentage of the value of the accounts factored. This ranges from 2.5 to 5 per cent. A smaller percentage, approximately 1 to 2 per cent, may be charged if the factoring company delays payment. For example, in the case of maturity factoring, payment may be delayed until 30 days after the invoice date. Credit card services provide almost immediate cash to the sellers because the amount of the credit dockets is credited to their bank accounts when the credit card dockets are deposited (electronically) at the bank.

Credit insurance
Another way of protecting against bad debt losses is to take out credit insurance. The insurance cover may be specific account or for the whole turnover. Specific account policies may cover a particular account or they may extend to all accounts that fall into a specified range of dollar values. Whole turnover policies cover bad debt losses on any of the company’s accounts. The insurance company does not provide a complete coverage against bad-debt losses. This is to guarantee that the insured company will try to recover the bad debt before making a claim. The premium for insurance cover ranges from 2 to 6 per cent of the value of the accounts receivable to be covered. The premium calculation would include the probability of a claim being made and if the risk was too high the insurance company would not issue a policy.

Delaying disbursements
Accelerating collections is one method of cash management; slowing down disbursements is another. The cash disbursement process is illustrated in Figure 13.4. Slowing down disbursements, or ‘playing the float game’ as it is sometimes called, generally involves increasing mail time and cheque-clearing time. This technique can be avoided if the company has many suppliers and customers; it makes it far easier to negotiate favourable collection and payable terms. In previous chapters we discussed where large retail outlets receive the money from their sales long before they pay for they pay for the goods. A weakness for any company is to rely on too few customers or suppliers.

Ethical and legal questions
The cash manager must work with collected bank cash balances and not the firm’s book balance (which reflects cheques that have been deposited but not collected). If this is not done, a cash manager could be drawing on uncollected cash as a source for making short-term investments.

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   Figure 13.4   
Cash disbursement

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   In May 1985, Robert Fomon, chairman of EF Hutton (a large US investment bank), pleaded guilty to 2000 charges of mail and wire fraud in connection with a scheme the firm had operated from 1980 to 1982. EF Hutton employees wrote cheques totalling hundreds of millions of dollars against uncollected cash. The proceeds were then invested in short-term money market assets. This type of systematic overdrafting of accounts (or cheque ‘kiting’ as it is sometimes called) is neither legal nor ethical.

   For its part, EF Hutton paid a $2 million fine, reimbursed the government (the US Department of Justice) $750 000, and reserved an additional $8 million for restitution to defrauded banks.

   In more recent times, on 5 November 2009 the Federal Bureau of Investigations, Atlanta Division, advised that Edward William Farley pleaded guilty to a $20 million fraud, part of which was a cheque-kiting scheme.

Concept questions
13.3a  What is the difference between:
i  a notification and a non-notification factoring agreement?
ii  a credit-risk factoring agreement and a non credit-risk factoring agreement?
13.3b  What is the difference between available balance and book balance called?
13.3c  Who maintains the accounts receivable ledger when a non-notification factoring agreement has been arranged?

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