Companies don’t keep their cash in a little tin box; they keep it in a bank deposit. To understand how they can make best use of that deposit, you need to understand what happens when companies withdraw money from their account or pay money into it.
FLOAT
Suppose that the United Carbon Company has $1 million in a demand deposit (checking account) with its bank. It now pays one of its suppliers by writing and mailing a check for $200,000. The company’s records are immediately adjusted to show a cash balance of $800,000. Thus the company is said to have a ledger balance of $800,000.
But the company’s bank won’t learn anything about this check until it has been received by the supplier, deposited at the supplier’s bank, and finally presented to United Carbon’s bank for payment. During this time United Carbon’s bank continues to show in its ledger that the company has a balance of $1 million.
While the check is clearing, the company obtains the benefit of an extra $200,000 in the bank. This sum is often called disbursement float, or payment float.
Float sounds like a marvelous invention; every time you spend money, it takes the bank a few days to catch on. Unfortunately it can also work in reverse. Suppose that in addition to paying its supplier, United Carbon receives a check for $120,000 from a customer. It first processes the check and then deposits it in the bank. At this point both the company and the bank increase the ledger balance by $120,000:
But this money isn’t available to the company immediately. The bank doesn’t actually have the money in hand until it has sent the check to the customer’s bank and received payment. Since the bank has to wait, it makes United Carbon wait too—usually 1 or 2 business days. In the meantime, the bank will show that United Carbon still has an available balance of only $1 million. The extra $120,000 has been deposited but is not yet available. It is therefore known as availability float.
Notice that the company gains as a result of the payment float and loses as a result of availability float. The net float available to the firm is the difference between payment and availability float:
Net float = payment float – availability float
In our example, the net float is $80,000. The company’s available balance is $80,000 greater than the balance shown in its ledger.
VALUING FLOAT
Float results from the delay between your writing a check and the reduction in your bank balance. The amount of float will therefore depend on the size of the check and the delay in collection.
As financial manager your concern is with the available balance, not with the company’s ledger balance. If you know that it is going to be a week before some of your checks are presented for payment, you may be able to get by on a smaller cash balance.
The smaller you can keep your cash balance, the more funds you can hold in interest earning accounts or securities. This game is often called playing the float.
You can increase your available cash balance by increasing your net float. This
means that you want to ensure that checks received from customers are cleared rapidly and those paid to suppliers are cleared slowly. Perhaps this may sound like rather small change, but think what it can mean to a company like Ford. Ford’s daily sales average over $400 million. If it could speed up collections by 1 day, and the interest rate is .02 percent per day (about 7.3 percent per year), it would increase earnings by .0002 × $400 million = $80,000 per day.
What would be the present value to Ford if it could permanently reduce its collection period by 1 day? That extra interest income would then be a perpetuity, and the present value of the income would be $50,000/.0002 = $250 million, exactly equal to the reduction in float.
Why should this be? Think about the company’s cash-flow stream. It receives $250 million a day. At any time, suppose that 4 days’ worth of payments are deposited and “in the pipeline.” When it speeds up the collection period by a day, the pipeline will shrink to 3 days’ worth of payments. At that point, Ford receives an extra $250 million cash flow: it receives the “usual” payment of $250 million, and it also receives the $250 million for which it ordinarily would have had to wait an extra day. From that day forward, it continues to receive $250 million a day, exactly as before. So the net effect of reducing the payment pipeline from 4 days to 3 is that Ford gets an extra up-front payment equal to 1 day of float, or $250 million. We conclude that the present value of a permanent reduction in float is simply the amount by which float is reduced.
However, you should be careful not to become overenthusiastic at managing the
float. Writing checks on your account for the sole purpose of creating float and earning interest is called check kiting and is illegal. In 1985 the brokerage firm E. F. Hutton pleaded guilty to 2,000 separate counts of mail and wire fraud. Hutton admitted that it had created nearly $1 billion of float by shuffling funds between its branches and through various accounts at different banks.
FLOAT
Suppose that the United Carbon Company has $1 million in a demand deposit (checking account) with its bank. It now pays one of its suppliers by writing and mailing a check for $200,000. The company’s records are immediately adjusted to show a cash balance of $800,000. Thus the company is said to have a ledger balance of $800,000.
But the company’s bank won’t learn anything about this check until it has been received by the supplier, deposited at the supplier’s bank, and finally presented to United Carbon’s bank for payment. During this time United Carbon’s bank continues to show in its ledger that the company has a balance of $1 million.
While the check is clearing, the company obtains the benefit of an extra $200,000 in the bank. This sum is often called disbursement float, or payment float.
But this money isn’t available to the company immediately. The bank doesn’t actually have the money in hand until it has sent the check to the customer’s bank and received payment. Since the bank has to wait, it makes United Carbon wait too—usually 1 or 2 business days. In the meantime, the bank will show that United Carbon still has an available balance of only $1 million. The extra $120,000 has been deposited but is not yet available. It is therefore known as availability float.
Notice that the company gains as a result of the payment float and loses as a result of availability float. The net float available to the firm is the difference between payment and availability float:
Net float = payment float – availability float
In our example, the net float is $80,000. The company’s available balance is $80,000 greater than the balance shown in its ledger.
VALUING FLOAT
Float results from the delay between your writing a check and the reduction in your bank balance. The amount of float will therefore depend on the size of the check and the delay in collection.
As financial manager your concern is with the available balance, not with the company’s ledger balance. If you know that it is going to be a week before some of your checks are presented for payment, you may be able to get by on a smaller cash balance.
The smaller you can keep your cash balance, the more funds you can hold in interest earning accounts or securities. This game is often called playing the float.
You can increase your available cash balance by increasing your net float. This
means that you want to ensure that checks received from customers are cleared rapidly and those paid to suppliers are cleared slowly. Perhaps this may sound like rather small change, but think what it can mean to a company like Ford. Ford’s daily sales average over $400 million. If it could speed up collections by 1 day, and the interest rate is .02 percent per day (about 7.3 percent per year), it would increase earnings by .0002 × $400 million = $80,000 per day.
What would be the present value to Ford if it could permanently reduce its collection period by 1 day? That extra interest income would then be a perpetuity, and the present value of the income would be $50,000/.0002 = $250 million, exactly equal to the reduction in float.
Why should this be? Think about the company’s cash-flow stream. It receives $250 million a day. At any time, suppose that 4 days’ worth of payments are deposited and “in the pipeline.” When it speeds up the collection period by a day, the pipeline will shrink to 3 days’ worth of payments. At that point, Ford receives an extra $250 million cash flow: it receives the “usual” payment of $250 million, and it also receives the $250 million for which it ordinarily would have had to wait an extra day. From that day forward, it continues to receive $250 million a day, exactly as before. So the net effect of reducing the payment pipeline from 4 days to 3 is that Ford gets an extra up-front payment equal to 1 day of float, or $250 million. We conclude that the present value of a permanent reduction in float is simply the amount by which float is reduced.
However, you should be careful not to become overenthusiastic at managing the
float. Writing checks on your account for the sole purpose of creating float and earning interest is called check kiting and is illegal. In 1985 the brokerage firm E. F. Hutton pleaded guilty to 2,000 separate counts of mail and wire fraud. Hutton admitted that it had created nearly $1 billion of float by shuffling funds between its branches and through various accounts at different banks.
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