Cash Management quiz

The annual benefit from using the lockbox system is the excess of interest earned on the early deposits over the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $2,000,000 ($20,000 average payment × 50 per day × 2 days).

The annual variable cost will be $9,125 ($.50 per payment × 50 per day × 365 days).

Benefit (loss) = Interest earned – Cost

                           = ($2,000,000 × 6%) – ($50,000 + $9,125)

                           = $120,000 – $59,125

                           = $60,875

The most direct way of preparing a cash budget requires incorporation of sales projections and credit terms, collection percentages, estimated purchases and payment terms, and other cash receipts and disbursements.

In other words, preparation of the cash budget requires consideration of both inflows and outflows.

A draft is a three-party instrument in which one person (the drawer) orders a second person (the drawee) to pay money to a third person (the payee). A check is the most common form of draft. It is an instrument payable on demand in which the drawee is a bank. Consequently, a draft can be used to delay the outflow of cash. A draft can be dated on the due date of an invoice and will not be processed by the drawee until that date, thereby eliminating the necessity of writing a check earlier than the due date or using an EFT. Thus, the outflow is delayed until the check clears the drawee bank.

Speeding up collections by 2 days will raise the firm’s average cash balance by $30,000. At 8% interest,

the benefit will be $2,400 annually [($15,000 × 2 days) × .08].

Compensating balances are either (1) an absolute minimum balance or (2) a minimum average balance that bank customers must keep at the bank. These are
generally required by the bank to compensate for the cost of services rendered. Maintaining compensating balances will not accelerate a company’s cash inflows
because less cash will be available even though the amount of cash coming in remains unchanged.

Cash disbursements for the month of April are calculated as follows:

April purchases:  $140,000× 40% = $ 56,000

March purchases:  $160,000× 30% = 48,000

February purchases:  $160,000× 30% = 48,000

April payroll:  $300,000× 10% = 30,000

April op. expenses:  $260,000× 20% = 52,000

Interest = 20,000

Total April disbursements = $254,000

Cash inflows for March would consist of 50% of March credit sales ($90 × 50% = $45), plus 30% of February credit sales ($120 × 30% = $36), plus 20% of January
credit sales ($100 × 20% = $20), plus cash sales for March of $18. Consequently, total collections equal $119,000.

Checks are currently tied up for 11 days (6 for mailing, 3 for processing, and 2 for clearing). If that period were reduced to 3 days, the firm’s cash balance would increase by $1,200,000 ($150,000 per day × 8 days).

The three motives for holding cash are as a medium of exchange, as a precautionary measure, and for speculation. Reason #1 can be classified as a precautionary
measure, and Reason #2 can be classified as holding cash for speculation.

A lockbox system is one strategy for expediting the receipt of funds. Customers submit their payments to a mailbox controlled by the bank rather than to the company’s offices. Bank personnel remove the envelopes from the mailbox and deposit the checks to the company’s account immediately. The remittance advices must then be transported to the company for entry into the accounts receivable system. The bank generally charges a flat monthly fee for this service.

Cash disbursements for the month of April are calculated as follows:

April purchases: $130,000 × 50% = $ 65,000

March purchases: 150,000 × 25% = 37,500

February purchases: 150,000 × 25% = 37,500

April payroll: 250,000 × 10% = 25,000

April op. expenses: 300,000 × 15% = 45,000

Interest = 25,000

Total April disbursements = $235,000

The additional annual income (loss) from using the bank’s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $600,000 ($300,000 × 2 days).

Benefit (loss) = Interest earned – Cost

                             = ($600,000 × 11%) – ($3,000 × 12 months)

                             = $66,000 – $36,000

                             = $30,000

Various methods of accelerating cash collections include decentralized collection outposts (normally one in each Federal Reserve District), electronic funds transfers, centralized banking for all company branches to avoid having to maintain minimum balances in several locations, and lockbox systems. A compensating balance is a minimum average or absolute amount that must be maintained in a bank account. Hence, it is not a means of accelerating cash collections. This requirement means that less cash is available to the depositor.

The additional annual income generated by Bank 4’s lockbox service can be calculated as follows:

Benefit (loss) = Interest earned – Cost

                             = ($300,000 × 2 days × 6%) – ($1,000 × 12 months)

                             = $36,000 – $12,000

                             = $24,000

The float period is the time between when a check is written and when it clears the payor’s checking account. Check float results in an interest-free loan to the payor because of the delay between payment by check and its deduction from the bank account. If checks written require 1 more day to clear than checks received, the net float equals 1 day’s receipts. The company will have free use of the money for 1 day. In this case, the amount is $10,000.

Multiplying 700 checks times 360 days results in a total of 252,000 checks per year. Accordingly, using a $0.50 fee per check, total annual cost is $126,000 (252,000 × $.50), which is less desirable than a $125,000 flat fee.

Given that the annual collections equal $453,600,000 (700 checks × $1,800 × 360 days), a fee of 0.03% of the amount collected is also less desirable because the annual fee would be $136,080 ($453,600,000 × .03%). The best option is therefore to maintain a compensating balance of $1,750,000 when the cost of funds is 7%, resulting in a total cost of $122,500 ($1,750,000 × 7%).

Checks are currently tied up for 10.5 days (5 for mailing, 4 for processing, and 1.5 for clearing). If that were reduced to 4 days, the firm’s cash balance would increase by $650,000 ($100,000 per day × 6.5 days).

An ACH electronic funds transfer (EFT is an electronic payment to a company’s account at a concentration bank. A concentration bank is a large bank to which a
company transfers funds from local depository banks. These local banks operate the company’s lockboxes and thus serve as collection points. The transfer of funds to the concentration bank allows the company to take advantage of economies of scale in cash management. The use of ACHs facilitates concentration banking. ACHs are electronic networks operated by the Federal Reserve (except for the New York regional ACH association) that guarantee 1-day clearing.

A lockbox system is a means of managing cash inflows, not outflows.

The additional annual income (loss) from using the bank’s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $600,000 ($200,000 × 3 days).

Benefit (loss) = Interest earned – Cost

                           = ($600,000 × 12%) – ($4,000 × 12 months)

                           = $72,000 – $48,000

                           = $24,000