The Check Clearing Process The process of receiving cash from customers involves several time-

The Check Clearing Process The process of receiving cash from customers involves several time-

consuming steps: ■ The customer sends the check.

■ The check is processed within the firm—so the customer can be cred- ited with paying. ■ The check is sent to the firm’s bank. ■ The bank sends the check through the clearing system. ■ The firm is credited for the amount of the check.

Several days may elapse between the time when the firm receives the check and the time when the firm is credited with the amount of the check. During that time, the firm cannot use the funds. The amount of funds tied up in transit and in the banking system is referred to as the float. The float occurs because of the time tied up in the mail, in check processing within the firm, and in check processing in the banking sys- tem. (See Exhibit 19.4)

The float can be costly to those who are on the receiving end. Sup- pose on average your customers make $1 million in payments each day. If your float is seven days, you therefore have 7 times $1,000,000 = $7,000,000 coming to you that you cannot use. If you can speed up your collections to five days, you can reduce our float to $5 million— and use the freed-up $2 million for other things.

But the float can be beneficial to the payer. Suppose you make pay- ments to your suppliers, on average, $1 million per day. And suppose it takes your suppliers five days after they receive your checks to complete the check processing system. You have $5 million in float per day. If you could slow down the check processing by one day, you increase the float to $6 million. That’s $1 million more cash available for you to use each day.

There are several ways we can speed up incoming cash: ■ Lockbox system A system where customers send their checks to post

office boxes and banks pick up and begin processing these checks immediately.

■ Selection of banks Choosing banks that are well connected in the banking system, such as clearinghouse banks or correspondent banks, can speed up the collection of checks.

■ Check processing within the firm Speed up processing of checks within the firm so that deposits are made quickly.

MANAGING WORKING CAPITAL

■ Electronic collection Avoid the use of paper checks, dealing only with electronic entries. ■ Concentration banking The selection of a bank or banks that are located near customers, reducing the mail float.

A clearinghouse is a location where banks meet to exchange checks drawn on each other, and a clearinghouse bank is a participant in a clearinghouse. Clearinghouses may involve local banks or local and other banks. Being a member of a clearinghouse can reducing check clearing time by up to one-half a day relative to clearing checks through the Federal Reserve system. A correspondent bank is a bank that has an agreement with a clearinghouse bank to exchange its checks in the clear- inghouse. Banks can become correspondents to clearinghouses in other parts of the country, reducing their check clearing time relative to clear- ing checks through the Federal Reserve system.

In addition, there are several methods you can use to slow up our payment of cash:

■ Controlled disbursements Minimizing bank balances by depositing

only what is needed to make immediate demands on the account. ■ Remote disbursement Paying what is owed with checks drawn on a bank that is not readily accessible to the payee, increasing the check processing float.

Consider the reduction in float by a local government. The city of Seattle, Washington, discovered that their float was quite large. 4 By tak- ing a closer look at their processing of checks and banking relation- ships, the city was able to reduce their float substantially. They improved their float by using a number of devices: adding bar codes on envelopes, processing mail electronically through the post office, chang- ing their mail pick-up routine, using optical scanning to record receipts, and using concentration banking. The result? They reduced the mail float by one day, reduced the office processing float by three and one- half days, and reduced the bank float by almost one day—a savings esti- mated to be approximately $1.3 million per year.

Whichever way you speed up the receipt of cash or slow down the payment of cash there is a cost. Firms must weigh the benefits with the cost of altering the float.

We will look closely at one speed-up device—the lockbox system— and one slow-down device—controlled disbursements—to see how the float can be altered.

4 Lloyd F. Hara, “Seattle’s ‘No-Float Day’,” Government Finance Review, Vol. 3 (December 1987) pp. 7–10.

Management of Cash and Marketable Securities

EXHIBIT 19.5 An Example of the Time Line Corresponding to a Lockbox System

The lockbox system may reduce the mail float (due to the placement of the lockboxes near the customer) and changes what was the “firm float” to a “bank float” since the bank now processes the checks received from customers.