Cash Management quiz

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.

The firm can compare the costs of the two alternatives as follows:

Standard account= Variable cost + Fixed cost

                                   = [(80 checks × $.10) + $10] × 12 months

                                   = $18 × 12 months

                                   = $216 per year

Premium account = Variable cost + Fixed cost

                                     = [$0 + ($2,500 reqd. – $500 projected)] × 10%

                                     = $2,000 × 10%

                                     = $200 per year

Thus, the premium account should be selected because it is cheaper by $16 per year.

The three motives for holding cash are :

(1) as a medium of exchange (the transactions motive),

(2) to provide a reserve for contingencies (the precautionary motive), and

(3) to take advantage of unexpected opportunities (the speculative motive).

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 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.

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.

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.

The annual benefit (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 $200,000 ($100,000 × 2 days).

Benefit (loss) = Interest earned – Cost

                             = ($200,000 × 6%) – ($500 × 12 months)

                             = $12,000 – $6,000

                             = $6,000

The difference between collections and payables is $5,000 daily. Five days’ worth amounts to $25,000 of float.

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).

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].

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 

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.

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

Investment risk is analyzed in terms of the probability that the actual return on an investment will be lower than the expected return. Comparing a project’s expected return with the return on an asset of similar risk helps determine whether the project is worth investing in. If the expected return on a project exceeds the return on an asset of comparable risk, the project should be pursued.

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 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.

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.

If cash outflows are $3 million per day, holding cash 2 extra days means that average balances should increase by $6 million. At a 10% interest rate, the additional $6 million would generate interest revenue of $600,000 per year. Thus, if the system can be acquired for $600,000 or less, it would be beneficial to do so.

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