Cash Collections

Collection, Disbursement, and Concentration Cash Collections

Overview

• Presented by: Jun Zhu

• Affiliation: Kelley School of Business

• The material covers key concepts in cash management, specifically focusing on processes related to collection, disbursement, and fund concentration.

Learning Objectives

• Understand the process and basic products of:
    - Disbursements
    - Collections
    - Concentration of funds

• Evaluate the benefits of concentration of funds.

• Analyze the costs and benefits of using different payment methods such as:
    - Lockbox for disbursement/collection
    - EFT (Electronic Funds Transfer) for disbursement/collection
    - Wire transfer for fund concentration

Collection Process

Typical Collection Process

• Step 1: Invoice sent to customer.

• Step 2: Customer sends payment along with remittance advice.

• Step 3: Vendor receives and processes the payment.

• Step 4: Cash application is performed.

• Step 5: Funds are deposited into the vendor's account.

Practice Exercise

• Scenario: Penny Blossom, a vendor of handmade hair clips, and the cash collection process.

• Question: Which sequence shows the correct cash collection workflow?
    - A) Receive customer payment first, then send invoice.
    - B) Deposit funds, then send invoice, wait for payment.
    - C) Send invoice, customer sends payment and remittance advice, process payment, deposit funds. (Correct Answer)
    - D) Customer sends payment, then send an invoice.

Understanding Float

Definition

• Float: The difference between book cash (ledger balance) and bank cash (collected balance), representing the net effect of checks that are in the process of clearing.

• Collection Float: Created by checks received by the firm, increasing book balances but not immediately changing collected balances.

Measuring Float

• Factors Influencing Float:   - Dollar Amounts   - Time Delays

• Example Scenario: Mailing a check for $500 to another state.
    - Mailing time: 5 days
    - Processing delay: 1 day
    - Availability delay at the recipient’s bank: 3 days

• To measure float, sum the effect of these delays on available funds.

Another Practice Exercise

• Scenario: XYZ Corporation receives payments in batches with varying collection float times:
    - Batch 1: $2,000,000 with 3 days delay
    - Batch 2: $3,500,000 with 2 days delay
    - Batch 3: $1,500,000 with 5 days delay

• Question: Calculate XYZ Corporation's average daily float based on provided data for a 30-day month.

Lockbox Processing Systems

Definition

• Lockbox: A collection tool where a financial institution (FI) or third-party vendor receives payments at designated post office box addresses, processes remittances, and credits payments into a payee’s account.

Advantages of Lockbox Systems

• Reduced Processing Float: Minimizes time funds are tied up.

• Improved Access to Remittance Information: Enhances visibility into incoming payments.

Process Overview

• Payments are mailed to post office boxes instead of the corporation directly.

• Bank collects remittances multiple times a day from post office boxes.

• Checks are processed and deposited into the company's bank account.

• Receivables details sent to the firm for processing.

Practice Exercise on Lockbox Effectiveness

• Question: Why is a lockbox system effective in reducing collection float for geographically dispersed customers?
    - A) Eliminates the need for customers to write checks.
    - B) Reduces time from mailing to availability of funds for the company. (Correct Answer)
    - C) Automatically transfers funds from customer accounts.
    - D) Allows higher pricing to cover processing fees.

Example: Penny Blossom's Financial Data

• Total sales: $9 million per month.

• Average check size: $9,000.

• Annual volume of checks: 12,000.

• Opportunity costs: 9%.

• Processing fee (internal): $0.25 per item.

Batch Details for Collection Float

Lockbox Cost/Benefit Analysis

Lockbox Cost Overview

• Total Annual Sales: $108 million ($9M/month).

• Annual Fee for Lockbox: $10,000.

• Processing Fee per Item: $0.50.

• Annual Volume of Checks: 12,000.

• Internal Processing Cost per Item: $0.25.

Float Analysis Without Lockbox

• Total dollar-days without lockbox system calculation:
    - Batch 1:
      - Amount: $1,500,000 x 4 days = $6,000,000
    - Batch 2:
      - Amount: $4,500,000 x 2 days = $9,000,000
    - Batch 3:
      - Amount: $3,000,000 x 6 days = $18,000,000
    - Total Float: $33,000,000
    - Annual Cost of Float: $ext{Average Dollar-Days ( } 1,100,000 ext{ )} imes ext{Opportunity Cost ( } 0.09 ext{ )} = 99,000$

Lockbox Float Reductions

Float Reduction by Lockbox

• Improvements possible through lockbox usage:
    - Batch 1: 4 days to 3 days
    - Batch 2: 2 days to 1 day
    - Batch 3: 6 days to 5 days

• Consequences:
    - Reduced total float from $33,000,000 to $24,000,000.
    - New annual cost of float: $ext{Average Dollar-Days ( } 800,000 ext{ )} imes ext{Opportunity Cost ( } 0.09 ext{ )} = 72,000$

Comparison of Protocols With and Without Lockbox

• Float Cost Without Lockbox: $99,000.

• Float Cost With Lockbox: $72,000.

• Float Cost Savings: $99,000 - 72,000 = 27,000$

• Lockbox Costs:
    - Fixed Costs: $10,000.
    - Variable Costs: $12,000 imes 0.50 = 6,000$.

• Internal Processing Cost Elimination: $12,000 imes 0.25 = 3,000$.

• Net Benefit Calculation:
    - $(27,000 + 3,000) - (10,000 + 6,000)$

Practice Exercise on New Lockbox Implementation

• ABC Company's Current Financials:
    - Current float costs: $150,000 annually.
    - Proposed float costs: $100,000 with lockbox.
    - Annual Fee for Lockbox: $20,000.
    - Per-item Processing Fee: $0.40 (for 50,000 payments).
    - Current Internal Processing Cost: $0.30 per item.

• Challenge: Calculate the net annual benefit or cost of lockbox implementation.

Another Practice Problem

• XYZ Corporation’s Financial Breakdown:
    - Batch 1 (Local): $3,000,000 with 3 days float.
    - Batch 2 (Regional): $4,000,000 with 5 days float.
    - Batch 3 (National): $2,000,000 with 7 days float.
    - Annual processing: 20,000 payments.
    - Opportunity Cost: 12% per year.

• Proposed Lockbox System Offers:
    - Batch 1 float reduced to 1 day.
    - Batch 2 float reduced to 3 days.
    - Batch 3 float reduced to 4 days.
    - Annual fee: $15,000.
    - Processing fee: $0.40 per item.
    - Current internal processing cost: $0.35 per item.

• Challenge: Estimate the net annual benefit of the lockbox system implementation.

Session Wrap Up

• Summary of processes, analysis of cash management tools, and critical thinking exercises surrounding implementation and financial implications of lockbox systems.