Reactive Cash Management

Consider some actual examples of companies that were reactive in managing cash—that is, they permitted long-established routines to continue and ignored appropriate working capital practices.

• Actual Situation I. A company received checks in the mail, created a deposit ticket, and had one of the older female employees walk the deposit to the bank on her way to lunch. The bank was located in an office plaza adjacent to the company's offices. This activity occurred every day at about the same time, so passersby could watch her on her journey.

  One of these observers realized that the woman was fairly defenseless, so he grabbed her bag containing the deposit, knocking her down and injuring her in the process, and easily got away. The deposit, including checks and some cash, was never recovered.

• Actual Situation II. Checks for monthly retail services were sent to a company whose name included the word “the” (as in “The Wiley Group”). The checks were received in the mailroom, where clerks opened all mail and directed it to the appropriate area of the organization. Any checks were supposed to be sent to the finance group for copying and deposit. One of the mailroom clerks noticed that some company names in the “pay to the order of” line left quite a bit of space between the words “the” and the company's name.

  When that occurred, the clerk inserted an “O” or an “A” in matching ink to change the recipient's name to Theo or Thea, then stole the check and deposited it in a bank account he had opened in that name (as in Theo Wiley Group). Months passed before customers realized that they had never received credit for their payments and notified the company.

• Actual Situation III. An insurance company issued a check for $70 to settle a claim for property damaged by its policyholder in an auto accident. The check was altered to $7,000 using inexpensive desktop technology and then cashed. Three months passed before the fraud was discovered, and by that time the check recipient had disappeared.

Each of these situations resulted from sticking to accepted routines, failing to consider risk, and ignoring modern cash management procedures. Situations I and II could have been avoided through the use of lockbox; situation III could have been prevented through controlled disbursement. We will examine those products in this chapter.

Essential Cash Management Elements

As noted in Chapter 1, the two critical factors in the optimization of cash are float and processing expenses:

1. An understanding of float is critical because all elements in the timeline of collections and disbursements have inherent delays, and delays cost a company. Although we cannot eliminate float, we can examine every step of the working capital timeline to search for savings opportunities.
2. Processing expenses are similarly important as each transaction—whether performed internally or outsourced—has a cost, and that cost directly impacts profitability.

Both factors can be managed through the use of various bank and vendor products.¹

Lockboxing Procedures

Lockboxing is a service that comprises several elements:

• Customers direct mail remittances to a bank-controlled post office box in major cities.
• Banks pick up mail numerous times each day beginning in the early morning.
• Mail is delivered to the bank's processing site.
• The lockbox area opens the mail, pulling checks and remittance advices.
• The lockbox determines whether any checks should not be deposited based on instructions from the company (such as the wrong payee or a postdated payment, one dated past the current date).
• A copy or image of each check is created.
• Acceptable checks are encoded³ and deposited.
• Availability is assigned, showing how rapidly the checks will be considered as collected funds based on the drawee bank, the bank on which the check is drawn.
• Summary information is sent to the company about the remittances, followed by electronic or paper versions of remittance documents and copies of the checks.

Lockboxing relieves companies of the burden and delay of handling mail and check deposits. The original form of lockbox services—known as wholesale lockbox—was established to handle low-volume, high-dollar checks. Critical data fields are manually key-entered from the remittance document such as the customer and/or invoice number. A retail lockbox is based on automated processing of scanlines (known as magnetic character ink recognition or MICR-lines) of documents and is used primarily for consumer payments.

Imaging is a technology that permits the digitized scanning, sorting, cataloging, and retrieval of paper documents, including checks, remittances, envelopes, and correspondence. The manipulation of an image replaces the labor-intensive process of handling wholesale lockbox items, while increasing the flexibility of the data captured and the scope and speed of receivables information transmitted to the company.

How Does Lockboxing Reduce Float?

Lockboxing eliminates the delays experienced when checks are directed to a business. The sources of these delays include the following:

• Late delivery of mail to suburban locations. Mail may be one-half to more than one day slower arriving at a noncentral city location, say on Tuesday at noon instead of Monday at 10 a.m., because of additional sorts and longer routes to reach the final destination.
• Holdover of mail due to internal processing steps. As an example, one company had a 24-hour turnaround rule, meaning that mail had to be processed and moved along within a day. The problem was that there were four separate workstations and four days (at best) before the checks were deposited!
• Depositing of checks at suburban banks. For convenience, many companies use nearby branches of their banks for deposits. The problem is that the bank courier stops by once a day at each branch, often as early as noon. Missing the courier's pickup means a one-day delay in starting the check-clearing process.
• Check clearing. Availability float is the term banks use to assign “good” or collected funds to checks that are deposited. Availability is based on a bank's recent experience in clearing the checks it receives, and is measured in zero days (for U.S. Treasury and on-us checks),⁴ one day (for major city and nearby suburban checks), two days (for distant locations), and three or more days (for checks written on nonbank financial institutions and foreign checks). Locating a depository bank distant from where checks are drawn can increase availability float by one-half day or more.

Lockbox speeds all of these activities, and can result in a savings of up to one-half of current total collection time, which can be six or more days. Costs vary, depending on the services provided by the bank, but they are never more than about $1 per transaction for wholesale lockbox and 25 cents for retail lockbox.

How Does Lockboxing Prevent Fraud?

Fraud may occur when cash and accounting functions are performed by the same individuals in a business office. Lockboxing places all cash handling under the management of a bank, which takes full responsibility for opening mail, pulling checks and other documents received, and making deposits of monies received. Notification is sent to client companies by any of various media as to each day's activity. Any loss due to bank error or theft is the responsibility of that financial institution.

In this situation, the only checks that are not under the direct supervision of the bank are those that are mailed or couriered to an office address rather than to the lockbox, and those handed to sales representatives rather than mailed. If a company aggressively pursues these practices, the possibility of theft is largely eliminated.

Control of Access

Regular bank accounts are difficult to monitor in terms of access, as companies often allow several authorized check signers to disburse deposited funds. The purpose of such payments may be entirely legitimate, but controls are often weaker than on lockbox and controlled disbursement accounts managed by the treasury staff, and internal auditors may only review the bank statements every two or three years. Furthermore, a disgruntled former employee who has taken check stock may write those checks to a phony business and then pocket the funds.

Multipurpose Accounts

Bank accounts are frequently opened at each facility of an organization for the convenience of staff, check encashment (cashing employee checks), or other reasons. Large companies with widely separated operations may receive requests to have access to local banks, and if funds are collected by a branch office, may simply open a local account, deposit these receipts, and disperse the funds for local expenses. All openings of bank accounts should require a board of directors resolution, and any such violations should be treated as a serious breach of company policy.

In Chapter 4, we examine the management of the bank relationship, including the mobilization of funds from depository accounts to the major banking relationship. It is perhaps sufficient to note that multiple bank accounts require time-consuming, active management, with associated processing costs, or the manager could choose to leave the funds in the depositories, which will cost float.

Too Many Accounts

As merger activity resumes, the surviving company may find that the number of their bank accounts is excessive and expensive. However, it may be reluctant to close accounts against which checks may have been written or which receive deposits. It is difficult to manage a large account configuration, particularly as accounts may have different purposes, authorized signatories, and other characteristics. Some accounts may be dormant, yet are costing monthly bank fees. The entire banking system should be investigated and accounts closed wherever possible.

Controlled Disbursement Procedures

Controlled disbursement accounts are located at large bank suburban or country locations specifically established for the purpose of receiving the presentment of a cash letter once or twice daily in the early morning hours.⁵ The bank notifies its corporate customers by midmorning of that day's check clearing (or debit) against the account. The customer then funds the debit once daily, eliminating the need to leave balances awaiting possible later clearings. Banks offering this product hold checks received later in the day or make clearing adjustments the next day for debiting to the account, eliminating the need for supplemental funds transfers to cover any shortfall.

Funding options include an internal bank transfer and an electronic transfer through Fedwire or ACH, both of which are discussed in the next section. The ACH credit does not become good funds until the next business day, so the bank will require the equivalent of the average check clearings of one or more days to be maintained in the account to cover the ACH float. Controlled disbursement costs about 15 cents per item.

Account Reconciliation

Any disbursement account must be reconciled monthly to match the bank's records with the company's own books and so that neither party has made an error that goes uncorrected. Banks now provide automated partial or full reconciliation to the company within 5 to 10 days of month-end. Partial reconciliation is simply a list of paid or cleared items, including check numbers and dollar amounts, that the company must then reconcile against its own ledgers. The cost is about three cents per item.

An affiliated (and recommended) bank product is full reconciliation, which takes the issued and cleared item files and matches them monthly. Companies are notified of matches, checks still outstanding, items cleared but not issued (when the bank did not receive the issued file or notice of a late exception item), duplicate items (forced postings), and other problems. This step can ensure that only checks properly issued are charged against the account. Full reconciliation costs about five cents per item.

How Does Controlled Disbursement Improve Float?

Controlled disbursement can improve float by extending the clearing time required for a check to travel from the deposit bank back to the drawee bank. This occurs because the drawee bank is located outside of major cities where clearing times are expedited by access to transportation, and because there are only one or two morning presentments of cash letters. The extension of float is typically about one-half day.

How Does Controlled Disbursement Prevent Fraud?

Controlled disbursement contains no fraud prevention controls, but associated products do allow financial managers to discover suspect checks. Many companies support controlled disbursement with positive (or match) pay, which requires that a file be sent to the bank containing the number and amount of each check issued that day. As the issued checks clear, the bank matches the number and amount to the check issued file. If any mismatches occur to either factor, the bank asks the company for accept or reject decisions. The daily files of issued check information can be accumulated by the bank into a file for monthly account reconciliation purposes.

Assuming that the protocols are followed, the honoring of any fraudulent check is prevented, such as those resulting from alteration or counterfeiting (e.g., the entire check is phony, which may result from using manipulated check images). Some banks now offer payee positive pay, which matches the payee's name on clearing checks to the issued file along with the check number and amount. Positive pay costs about five cents per item.

Federal Wire Transfer

Federal wire transfer (Fedwire) is processed on a same-day basis without settlement risk to the participant, as the Federal Reserve System guarantees payment. Most businesses do not often have need for Fedwire, because there are few situations where funds must be moved that day. Financial services companies are the largest users of this system due to the volume of the funds and their value, and because regulations governing these industries force the immediate crediting of funds to investors' accounts.

Fedwire advantages are the following:

• Value: Companies receive immediate, same-day value.
• Speed: Transfers are very fast. However, a few hours' delay might occur at peak operating times.
• Security: Fedwire is reliable and secure.

Disadvantages are the following:

• Cost: Fedwire is expensive to use relative to other payment types. At about $15 at each end of the transaction, or $30 or more, Fedwire is 200 times the cost of ACH.
• Limited automation linkages: Not all financial institutions are online with the Fed and so have to make alternative arrangements, which can slow the process and introduce errors.

Automated Clearing House (ACH) networks offer an electronic alternative to checks.⁷ The ACH system was established to effect inexpensive settlement of low-value, high-volume and repetitive payments on an electronic, batch, overnight basis. Credit transactions are used for direct deposit of payroll, pension, and annuity payments. Debit transactions, also known as direct debits, are used for consumer bill payments, such as utility bills, phone bills, and insurance premiums. Corporate use has been largely for cash mobilization and payroll. The total number of ACH transactions is now about 22 billion a year, slightly more than the number of checks written.

ACH advantages include the following:

• Value: Payments can be made on precise settlement dates.
• Reliability and efficiency: Compared with checks, ACH collections follow a more predictable pattern.
• Electronic processing and interfaces: ACH allows for automated interfaces to reconciliation and cash application systems.
• Payment options: ACH handles debit as well as credit transactions, providing opportunities for improved collection processes.
• Information: Large amounts of information can be transferred with the payment.
• Cost: The typical ACH charge is 15 cents (or less for high volumes).

ACH disadvantages include the following:

• Delayed settlement: ACH payments generally settle the day following the payment's initiation; in contrast, Fedwire settles same-day.
• Finality: ACH does not offer the same guarantee of finality as Fedwire, as debits can be returned if not honored by the bank due to insufficient funds.

Terminal-Based Electronic Payments

Banks have long provided access to Fedwire transfers for their business customers through terminal-based electronic systems; we'll discuss information products in Chapter 10. Fedwire transactions have various levels of approval, requiring that separate, designated financial managers set up, sign off on, and release any disbursements. In this way, fraud can occur only through the collusion of several individuals. Companies can now send and receive ACH transactions through the Internet with equivalent safeguards.

Why Do Frauds Still Occur?

We have spent some time in this chapter discussing ways to prevent fraud. Despite the proven efficacy of bank products, frauds do occur to the extent of some $10 billion a year or more in the United States. Here are some the common reasons companies give for not instituting stronger fraud protection:

• “We're too small.” Companies that have about $500 million or less in annual sales have a higher rate of fraud than large businesses. Smaller companies often do not separate accounting and cash handling responsibilities. This situation is an invitation to employee fraud and should be avoided. This is a particular problem with long-term, trusted employees who are “above suspicion” of larceny or other criminal behavior.
• “Our bank doesn't have these products.” Bankers may not call on smaller companies to explain cash management products, either because potential revenues are too small or because the banker does not understand or does not have the product. The solution is for the financial manager to become educated about these products and contact community and/or regional banks that can provide them.
• “Our auditors never told us.” Auditors may not be familiar with the very products that can protect their clients! While the accounting profession does require continuing education for CPAs to retain their licenses, there may not be adequate education on fraud problems and solutions outside of traditional accounting.
• “These are our longtime, trusted employees!” Studies of patterns of fraud indicate that it is precisely the longtime, trusted employee who may commit the fraud. There are various factors that may be in effect: a family situation requiring access to money, resentment at a newer employee who may be perceived as being favored, an addiction that costs more than a paycheck can support, and so on. Regardless, the solution is to transfer as much of the cash-handling function to a bank as possible.

Base Case

A company with $50 million a year in sales uses a bank to deposit its cash receipts—assume $200,000 per day in 500 payments (including checks and other forms of collection) from the sale of product and associated revenues. We'll look at each component of the collection cycle later; for now, just consider those checks received at an office in the regular mail delivery at 11:30 a.m.

As the USPS mailperson is leaving, the office staff heads off to lunch, not to return until 12:30 p.m. The mail is then distributed and opened, checks are pulled and copied, and the treasury manager prepares a deposit ticket. It is now 1:30 p.m. The office assistant drives the deposit to a bank located in a shopping center perhaps two miles away.

What are the costs so far or are yet to be incurred? The answer may be surprising but is critical in understanding the working capital opportunities.

1. Time in the mail from the customer to the office address (mail float): 3.5 days.
2. Time lost before the deposit begins to be processed by the bank (holdover float): 1.0 day.
3. Time to convert the deposit to “good” funds (availability float): 1.5 days.
4. Total staff time to prepare and make the deposit: 3.5 hours.

What happens next is the application of receipts to accounts receivable, resolving any discrepancies, and the verification of the stamped deposit ticket copy against the bank's deposit report. Decisions must be made regarding the use of the “good” funds we receive—invest, reduce existing loans, or pay incoming invoices or payroll. (Good funds are those to which the bank allows access, and have completed the availability process.) Those costs are added in as well:

5. Time to apply receipts to receivables and verify the deposit: 3.5 hours
6. Time to manage good funds: 1.0 hour.

Finally, the bank must be paid for its services:

7. Bank fees to handle deposit and report on the daily transaction: 25 cents per check (plus $2 per deposit and $1 per daily report).

This all adds to a surprising amount of annual cost.

Baseline

Note: All staff hourly costs are valued at $25, including benefits.

While we cannot eliminate the $200,000, we can manage this amount down to a somewhat smaller cost.

Possible Improvements

Based on the ideas discussed in this chapter, the float time can be reduced to 3.5 days and the staff time can be managed down to 3.5 hours. The float reductions are in mail, holdover, and availability float. The staff time is in processing the mail, creating the bank deposit, and taking the deposit to the bank. The bank charges will rise by the lockbox cost, which will include an incremental $75 per month for the product and 75 cents per lockbox deposit.

First Scenario

The savings so far are $15,000 annually.

Second Scenario

This alternative assumes that we can convert one-fourth of our mailed payments to ACH electronic transactions.

The savings are now $25,000 a year. And there are other benefits that we did not have earlier:

• Control: All payments are directed to a lockbox or are paid electronically, so employees do not handle the cash.
• Convenience: The bank handles tasks that can require several hours each day of employee time.
• Credit and collection information: The credit manager can know the same day whether customers have paid their invoices and if it is appropriate to ship them new merchandise.

The true savings are certainly greater than $30,000, because the company has avoided theft, saved employee time, and learned as soon as possible whether customers have paid. Each company must determine the value of these savings, but $50,000 a year (on an original cost of $200,000) is certainly within the experience of U.S. companies.