5 CASH MANAGE MENT . CASHCONCIE SYSTEMS: TRATION SY TEMS INTRODUCTION Concentration i i f iiatorhetae ton is ne a neglected Part of cash management because firm: tend to think Ss in their banking system, the battle is over, Nevertheless there are significant that cash is moved efficiently to accounts > 8 & & 8 g z g 5 E 2 » concentration. There are two reasons why cash concentration is advantageous: First, the collection process results in a larger pool of funds. The larger pool makes any temporary interest- earning investments more economical because it reduces the transaction costs on investment. For example, if the firm gathers & 10,000 from each of 10 accounts, the firm will have & 1,00,000 to invest, resulting in one purchase of securities rather than 10. Also, the larger amount of funds may enable the firm to take advantage of higher-interest investments that require a larger minimum purchase. Second, with all the cash in a central location, keeping track of the cash (controlling the cash) is considerably simplified. This chapter describes how firms prepare the next step: the task of cash concentration, or moving cash from desposit banks into the firm's central cash pool, residing in one or more concentration banks. It is not sufficeint enough to collect cash and have it deposited into one of the firm's deposit accounts. Cash must be usable by the firm. It must be | moved into an account where it can be actively put to work. | CASH CONCENTRATION TASKS A concentration system consists of deposit banks, which feed cash into a concentration bank and disbursement banks, which draw cash from a concentration bank. In addition, the concentration bank is tied to a portfolio of short-term investments and borrowings. This Portfolio is a to balance out any excesses or deficiencies in the concentration account. A fone - he imply a bank designated by the firm to perform three main tasks: (1) receive sepia on bal |in the firm’s collection system. (2) transfer funds to the firm’s disbursement banks, an: it and i i form the last function, -term credit and investment transactions. To pe f Tn high, extra cash is moved as the focal point for sho cash in the concentration bank is monitored. When the level becomes too © scanned with OKEN Scanner440 WORKING CAPITAL MANAGEMENT it lines. When the level di into short-term investments or used to pay off credit lines. Wh iPS to lay, cash is supplied by the sale of short-term investments or from a draw on short-term bono, itic ment, sources. This process is called aggregate cash position manage! Though any bank can theoretically serve as @ concentration bank. most firms use g lay commercial bank for this purpose. The reason is thata concentration bank often Serves addition functions besides the three mentioned. First, it may provide a balance-reporting function. Sus reporting services gather information from the firm’s banking system and Provide a daily por of the firm’s deposits, disbursements, and balances. Second, a concentration bank often serves5 a source of short-term security investments and short-term liquidity in the form of credit line, Third, it provides assistance in preparing concentrating transfers. Small banks generally canna perform all of these functions, Although it is possible to receive these services from parties other than the concentration bank, administration is simplified, it is argued, if the concentration bank provides them all as a package. ADVANTAGES OF CONCENTRATION Cash concentration simlipfies short-term borrowing and investing decisions. If deposit at more or less routinely transferred to the concentration bank, the finance manager need only make decisions about what to do with cash balances, Concentrating cash into a central cash pool also facilities investment in short-term securities. Money market securities that give the highest rates are sold in large demonstrations. Accumulating cash in a concentration account provides the quantities needed to purchase sech cents Short term forcasting is usually simpler fora concentrated account than for individual deost and disbursement accounts, This is because forecast errors in smaller accouree in om Cs other when summed over the fitm’s banking system. This is important in fees wit ne needs. It is much easier o have one large credit line tied toa concentration arene eee fl credit lines tied to cash bank in the firm’s system, account than many small OBJECTIVE FUNCTION OF CASH CONCENTRATION Cash concentration costs arise from several sources: (1) oj i , balances in deposit banks, (2) transaction costs of moving cash imo the ie sa holding excess the value of dual balances (in which the same cash is counted in both the denen bank, (3) concentration bank atthe same time). (4) administrative costs of managing the c sei system, and (5) control costs associated with the risks of cash losses encountered in some concentration systems, Each of these cost factors center expressed qualitatively in an ones: funetion: Minimise opportunity costs of excess balances plus tansastion costs minus ince sate dual balances plus administrative costs plus control costs. The dual-balance factor has a negative sign because as dual balances increase, costs are reduced. The dual-balance cost does not exist forthe collection portion of the cash flow timeline, but it may be present in certain concentration systems, Dual balances arise in concentration systems because of inefficiencies in the transfer clearing mechanism. si balances generally occur when a deposit into the concentration bank receives availability at the ration bank © scanned with OKEN ScannerCASH MANAGEMENT SYSTEMS: CASH CONCENTRATION SYSTEMS 141 before the transfer clears the field bank. During the ti “owns” cash at two different banks, ees aso tena. oe eo To inteligently desig rath f i eer gently design a concentration system and establish concentration policies it is necessary to deal with all five of these cost factors simultaneously. CASH CONCENTRATION PRACTICE Field Versus Lockbox Concentration Systems : There are two basic types of concentration systems, each associated with a potentially different set of problems and practices. The first is a field banking system, which collects cash and other over-the counter deposits. The second is a lockbox banking system, which collects mailed deposits. The characteristics of the two are contrasted in Table-1. TABLE-L Contrasting Field and Lockbox Concentration Systems Feature Field System Lockbox System Number of banks Usually many Fewer than 10 Bank size Usually small Usually large Source of deposit Over the counter Mailed in Geographical constraints Bank must be near a cash Bank can be anywhere collection point Deposit size Relatively small Often large Type of deposit Cash and cheques Cheques only Availability Information from bank ‘Account analysis Services Usually immediate Monthly. statement Generally none Coin and cash deposit and transfer Often delayed by availability schedule Monthly statement Daily balance and deposit report Customary Wide variety; sometimes credit REDUCING CASH CONCENTRATION cost Various technique for reducing costs seek to reduce one or more cost factors. The goal is to realise an overall reduction. Processing, and Clearing Delays marily by delays in gathering and processing deposit information the deposit bank. Reducing Information, Excess balances are caused prir and by clearing transfers back to : In ie cessing Delays ee ae nformation from field managers. Once firm, for D ceur in receiving deposit in ; c 1 Eat reaurer deposi information to be gathered along with sales and inventory information © scanned with OKEN ScanneriO JEMENT 4 dRKING CAPITAL MANAGE f nae Jovels. The result is w delay of several days bef, jon to pass along to the concentration bank, 8 and routing it directly to the cash manager ? and processed through several seinen the cash manager receives deposit informat n removitiy deposit information at an early stage mit rextuotion in excess balances is realised, signit : ‘ ; Another tiem finds fhequent delays caused by field managers” irregular reporting habits. Thi, tiem begins including reporting prompmess as part of its field bila paint . Again, excess tnatances are signiticantly reduced, Generally, no complex mathematical algorithms are required g trace thnonigh information and processing pathways in order to determine ways to shorten thy timeline, Anticipation Moving Trangfer Initiation Forward ; Anticipation means initiating a transfer at the concentration bank before cash ‘becomes available at the deposit bank. Thus, by the time the transfer clears the deposit bank, available cash will be there to cover the transfer. This is essentially a method for counteracting information and processing delays. There are (vo types of anticipation, one less risky than the other, Ledger anticipation means to initiate a transfer on the basis of ledger deposit information from the deposit bank, Ledger deposits according to an availability schedule, Thus it is known with Virtual certainty that a ledger deposit will be converted into an available deposit on a known date and will be able to cover a transfer on that date. There is little risk of overdraft with this form of anticipation, Ledger anticipation presupposes that management has access to ledger deposit information before the ledger deposit becomes available. Many lockbox banks, however, report ‘on next-day ba! they post deposits to accounts late in the evening and let the firm know the next morning about the amount of the ledger deposit. By then, of course, much of the deposit has already become available. Deposit anticipation means to initiate a concentrating transfer before expected deposits int deposit bank have been reported, Deposit anticipation, however, is clearly more risky than ledge anticipation, since there is no guarantee that the amount will be deposited. Furthermore, depost anticipation may require some form of forecast of daily receipts and may entail more comple® teconcilement of transfers and deposits, Faster Transfer Mechanisms were Another way to reduce excess balances i rp fast fe where | y ss balances is to employ el i exets Gis acu y a faster transfer mechanism : Reducing Transfer Costs There are wo primary way ‘mechanism and transfer le We must trade assume that a d ys to reduce transfer a 88 often than daily, If the le Off speed with cost, One appr leposit of D ay We tse mechanism A Wire and tikes 7 days, As an alte whieh costs ©, per tra T Costs choose a less expensive ae Fi Ss expensive transfer mechanism is SIO ‘ouch is ¢ is. To il mount ihe S (0 Use a breakeven analysis. TO illus t to Cranage bank is an excess balance earning no inte ter it to the concentrati kK. tative, the Damount couldn bank, the cost of Gy vee and takes T. divs Nd be transferred using mechanism ‘ntl » days. The opportunity cost of leaving.the deposit © scanned with OKEN Scanner444 WORKING CAPITAL MANAGEMENT that permit firms to specify which days should be transfer days. This enables firms to depart fron the customery—perhaps suboptional—practice making transfers equal deposits and allows then to balance average and perhaps use anticipation. Administrative Control Systems Other firms have developed their own concentration administrative control systems that incorporate cash flow forecasts into anticipatory transfers. One firm, for example develops a daily cash forecast of the next week’s deposits for each store in its chain. The forecast is based on previous weeks’ sales reports. Improving Concentration Control A major component of control in field systems is theft and fraud control. The concentration system should provide safeguards that minimise the possibility of cash being taken from field points before entering the firm’s banking system. When complete control is left in the hands of the field manager. this can be a serious problem. One way to reduce the risk of loss is to obtain verifying deposit reports from the deposit bank. Most field banks are not part of balance reporting networks, so 2 source of information common in lockbox systems is lacking in field ¢ oe To overcome this problem. one firm requires its field banks to inform to a third-party ees gatherer with a report of the day’s deposits. This provides a confirmin ‘ sour it i 0 substantiate the report from the field manager, 8 Source of deposit information t Unfortunately, most firms rely on insufficient-funds notice to potential problems. If the field manager has not been deposi some firms find out is by eventually overdrafting the ace. concentrate the cash, Systems that have large excess balances than systems that exercise more control, s from the field bank to alert them ting cash as reported, the only waY ‘Ount when attempts are made t0 are likely to take longer to overdraft © scanned with OKEN Scanner