Cash Management Techniques

Cash management has changed significantly over the last 20 years for two reasons. First, from the early 1970s to the mid-1980s, there was an upward tread in interest rates which increased the opportunity cost of holding cash. This encouraged financial managers to search for more efficient ways of managing cash. Second, technological developments, particularly computerized electronic funds transfer mechanisms, changed the way cash is managed.

Most cash management activities are performed jointly by the firm and its banks. Effective cash management encompasses proper management of cash inflows and outflows, which entails (1) synchronizing cash flows, (2) using float, (3) accelerating collections, (4) getting available funds to where they are needed, and (5) controlling disbursements. Most business is conducted by large firms, many of which operate regionally, nationally, or even globally. They collect cash from many sources and make payments from a number of different cities or even countries. For example, companies such as IBM, General Motors, and Hewlett Packard have manufacturing plants all around the world, even more sales officers, and bank accounts in virtually every city where they do business. Their collection points follow sales patterns. Some disbursements are made from local offices, but most are made in the cities where manufacturing occurs, or else from the home office. Thus, a major corporation might have hundreds or ever thousands of bank accounts and since there is no reason to thinks that inflows and outflows will balance in each account, a system must be in place to transfer funds from where they come in to where they are needed, to arrange loans to cover net corporate shortfalls, and to invest net corporate surpluses without delay. We discuss the most commonly used techniques for accomplishing these tasks in the following sections.

Cash Flow Synchronization

If you as an individual were to receive income once a year, you would probably put it in the bank, draw down your account periodically, and have an average balance during the year equal to about half your annual income. If you received income monthly instead of once a year, you would operate similarly, but now your average balance would be much smaller. If you could arrange to receive income daily and to pay rent, tuition, and other charges on a daily basis, and if you were confident of your forecasted inflows and outflows, then you could hold a very small average cash balance.

Exactly the same situation holds for businesses – by improving their forecasts and by arranging things so that cash receipts coincide with cash requirements, firms can reduce their transactions balances to a minimum. Recognizing all this, utility companies, oil companies, credit card companies and so on, arrange to bill customers and to pay their own bills, on regular “billing cycles” throughout the month. This synchronization of cash flows provides cash when it is needed and thus enables firms to reduce cash balances, decrease bank loans, lower interest expenses, and boost profits.

Speed up the Check-Clearing Process

When a customer writes and mails a check, this does not mean that the funds are immediately available to the receiving firm. Most to us have been told by someone that “the check is in the mail”, and we have also deposited a check in our account and then been told that we cannot write our own checks against this deposit until the check-clearing process has been completed. Our bank must first make sure that the check we deposited is good and the funds are available before it will give us cash.

In practice, it may take a long time for a firm to process incoming checks and obtain the use of the money. A check must first be delivered through the mail and then be cleared through the banking system before the money can be put to use. Checks received from customers in distant cities are especially subject to delays because of mail time and also because more parties are involved. For example, assume that we receive a check and deposit it in our bank. Our bank must send the check to the bank on which it was drawn. Only when this latter bank transfers funds to our bank are the funds available for us to use. Checks are generally cleared through the Federal Reserve System or through a clearinghouse set up by the banks in a particular city. Of course, if the check is deposited in the same bank on which it was drawn, that bank merely transfers funds by bookkeeping entries from one depositor to another. The length of time required for checks to clear is thus a function of the distance between the payer’s and the payee’s banks. In the case of private clearinghouses, it can range from one to three days. Checks are generally cleared through the Federal Reserve System in about two days, but mail delays can slow down things on each end of the Fed’s involvement in the process.