CASH MANAGEMENT PRIMER

Transcription

1 CASH MANAGEMENT PRIMER An Introduction to the Fundamentals Produced by CJVolk Associates, Inc.

2 Preface This booklet is intended to provide an introduction to basic concepts and the tools of cash management. It should prepare you to discuss basic banking services with your bank s cash management officer. It should also make you aware of issues to be addressed in managing and controlling cash flow within your company or organization. This booklet is not intended to provide a comprehensive discussion of all aspects of cash management. There are several excellent publications and seminars providing the full scope of cash management knowledge, some of which are listed in the Appendix. If you are or become responsible for cash management, or simply wish to learn more about cash management, you should find these resources valuable.

3 Cash Management Primer Table of Contents PREFACE 2 WHAT IS CASH MANAGEMENT? 4 HOW DID CASH MANAGEMENT DEVELOP? 5 WHAT IS THE BASIC CASH MANAGEMENT PROCESS? 6 CASH FLOW CYCLE 7 COMPONENTS OF FLOAT 8 HOW DOES MONEY MOVE? 9 PAYMENTS CLEARING 9 FED WIRE 10 ACH 11 HOW ARE CASH MANAGEMENT SYSTEMS ESTABLISHED? 12 CASH MANAGEMENT BANK ACCOUNT STRUCTURES 14 HOW IS INFORMATION ABOUT MONEY MOVEMENT TRACKED AND RECORDED? 15 WHY IS BANK RELATIONSHIP MANAGEMENT IMPORTANT? 16 BANK FEES 17 HOW DO YOU INVEST SURPLUS CASH? 18 INVESTMENT POLICY 18 MONEY MARKET INSTRUMENTS 18 HOW ARE CASH SHORTAGES MANAGED? 19 DOES INTERNATIONAL CASH MANAGEMENT DIFFER SIGNFICANTLY FROM THE US? 20 WHAT RESOURCES ARE AVAILABLE TO LEARN MORE ABOUT CASH MANAGEMENT? 20 APPENDIX 22

4 What is Cash Management? Cash management is the movement of funds through financial institutions to optimize liquidity. It is the management of corporate funds to increase interest income earned by maximizing investments and/or reducing interest paid by minimizing borrowings. Cash management uses the knowledge of funds movement through the banking system, coupled with banking services and other financial products, to optimize liquidity. It is the scheduled gathering of information about a company s cash flow, its receipts, disbursements, and balances. This information is used to manage these elements of working capital. Effective cash management ensures the timely provision of cash resources necessary to support the company s operations. With the use of basic cash management tools and techniques, cash becomes a corporate asset that contributes directly to the bottom line. Whether a company is flush with cash or experiencing a shortfall of funds, good cash management is critical to the success of every company. Cash management is a financial discipline that uses the same principles, regardless of the type of business, size or age of an enterprise. Cash management is not an accounting function. The accountant records and reports transactions historically; the cash manager plans and executes these financial transactions. Cash managers use techniques, products and services to efficiently manage cash resources and satisfactorily resolve cash shortages or surpluses. The major elements of cash management are: Deposits: Receiving funds and depositing receipts into the bank account as quickly as possible, while collecting adequate information to correctly identify the source of the payment. Concentration: Moving funds to a central location from which they are more efficiently managed for investing and disbursing. Disbursement: Paying funds by check or electronically to vendors, employees, investors, and others. Information gathering, analysis and control: Reporting funds information, including: current cash position, forecasted shortages and surpluses, cost-benefit of proposed changes in cash management operations or outsourced services, interest rate or foreign currency risk exposure, and many other monetary circumstances which affect corporate resources. A cash manager s duties typically include: Monitoring the daily cash position. On a daily basis, the cash manager typically spends the first part of the day developing the cash position. This exercise identifies shortages and surpluses in time to either borrow funds to cover the shortfall or invest excess funds. The cash manager first confirms the prior day s closing balance, typically using on-line or Internet bank reporting. Forecasted and scheduled disbursements, receipts, loan repayments, and maturing investment proceeds are then added and subtracted to calculate the day s cash flow. The cash manager also typically administers the credit facility borrowing on a day-to-day basis. This daily reconciliation process also provides an effective method of immediately revealing unauthorized or fraudulent transactions. Controlling balances on deposit. The cash manager maintains bank balances at a level adequate to avoid overdrafts and to compensate the bank for cash management services. Short-term borrowing may be necessary to meet the required balances. Excess funds are typically invested, short-or long-term, until they are required to cover capital or operating expenditures. Moving funds as necessary. The cash manager may control several different bank accounts, perhaps in different states or even foreign countries. The transfer of monies from one account to another is often a daily exercise to prevent cash shortages in the accounts and to promptly invest surpluses. Managing short-term (working capital) borrowing and investing. Whether a company is an overall investor or borrower, the unsynchronized timing of operating cash flows requires the cash manager to be both a borrower and an investor. On any given day, the cash manager may borrow to meet shortterm cash requirements or invest surplus cash. Page 4

5 Forecasting future shortages and surpluses. To determine the amount and various maturities of the investment portfolio, the cash manager must predict future cash flows. Investing for a shorter period than necessary usually results in lost earnings; and investing for too long may cause premature security sales at a loss if funds are needed before maturity. Forecasting also allows the cash manager to plan for an adequate level of short-term credit facilities. Managing banking relationships. The cash manager maintains a mutually beneficial relationship with the company's bankers. If the cash manager develops an open and straightforward relationship, the banker can develop a good understanding of the company s operations and can bring relevant banking products and services to the attention of the cash manager. Performing analytic reviews and feasibility studies of banking services. The cash manager is the employee with primary responsibility for evaluating the benefits and drawbacks to adding new or terminating existing banking services. A company selects a bank that offers reliable, cost-effective services. The cash manager is responsible for monitoring the bank s services and fees to ensure that the arrangement remains satisfactory and that pricing is contractually accurate. Analyzing, designing and implementing cash management systems and procedures. Through the day-to-day tasks involved in their job, cash managers know system requirements to carry out cash management efficiently. Cash managers have a professional responsibility to keep up-to-date on developments in cash management products and practices by attending conferences, reading journals, and other networking and continuous learning activities. While growing professionally, the cash manager acquires and updates the skills and knowledge necessary to implement the cash management systems and procedures best suited to the company objectives. How did Cash Management develop? Cash management in the U.S. has been shaped by the structure of the domestic banking system, the U.S. Postal Service, and the prevalent use of checks for payment. The U.S. is unique in its large number of banks with limited national branch banking and its convention of bill payment primarily by check through the U.S. mail. Legislative and regulatory influences have also played a major role in the development of current cash management practices and continue to do so today. Modern cash management can be traced back to 1947, when the Radio Corporation of America (RCA) set up a lockbox collection system for dealers to deposit payments to RCA for loans to finance inventory. Payments were mailed to a special post office box set up exclusively for these payments. The bank collected the mail directly from the post office box and deposited the checks directly into RCA s bank account. Cash management responded to rising interest rates in the 1960s and 70s by becoming increasingly sophisticated. Corporations recognized cash as an asset able to generate income and saw that there could be a monetary return for actively managing cash. Many of the banking products used by cash managers today were developed during this period of runaway inflation: controlled disbursement, funds concentration, real-time transaction reporting, and electronic payments. Later, financial markets erupted with innovative instruments and products. The introduction of Negotiable Certificates of Deposit (CD) was the result of banks managing their assets and liabilities more aggressively. A secondary market for trading these instruments quickly developed as corporate treasurers realized they could invest otherwise idle bank deposits in these relatively risk-free instruments and, if necessary, have access to the funds before maturity. Cash managers were offered many new investment options, including banker s acceptances, repurchase agreements, and commercial paper. The explosion of desktop computing in the 1970s and 80s, coupled with corporate computer applications development, made a major impact on cash management. Cash managers could now easily concentrate bank balances into a central Page 5

6 account by electronic funds transfer, retrieve information automatically from banks on a timely basis, and perform transactions in real time and on-line. The electronic spreadsheet streamlined the generation of cash position reports and analytical tasks such as cash forecasting, which provided management critical information for strategic planning. In the 1990s, the financial environment turned its focus to risk management: bank creditworthiness, payments system risks, and use of derivatives to hedge against financial risks more precisely. Security concerns generated a flurry of legislative and regulatory activity. At the beginning of the 21st century, cash management has developed a global emphasis, as the world s capital markets become more closely aligned and local economies have become so broadly international. Technology, including the Internet, is now used extensively in cash management in most enterprises. Technological enhancements have led corporate management to expect even more from their treasury departments. The efforts toward benchmarking, re-engineering, and outsourcing that began in the late 1990s continues to gain momentum. What is the Basic Cash Management Process? Every successful company has a pool of cash that sustains the day-to-day activities of business. It grows with receipts from sales and contributions and shrinks with expenditures for inventory, marketing, labor and other expenses. The uncertainty of cash inflows and outflows creates the challenge of ensuring that sufficient funds are available at all times to support the operating cycle. Cash flows of both types must be closely managed. There are a variety of cash management tools and techniques to assist in this process, which will be discussed later. Borrowing becomes necessary when cash flow falls short of covering disbursements. When incoming funds exceed the outflow, cash is used to repay borrowings or purchase short-term investments until the cash is needed to cover future expenses. Financial officers need timely information to properly control and use their funds throughout the cash flow cycle. The Basic Cash Management Process provides that timely information. The cash flow timeline includes the total time interval beginning with the first phase of the operating cycle, when resources are purchased, until the last step when receipts are collected. It consists of the following steps: 1. Material purchases. Acquisition of raw materials or merchandise for resale includes negotiation of the method of payment, credit terms and trade and payment discounts. 2. Payment for resources. All resources required to support sales, including labor, marketing and overhead expenses, incur financing costs until cash is collected for sales made. By managing the timing of disbursements, the cash manager can minimize implicit financing expenses. 3. Sale of inventory or services. Merchandise and other sales are most frequently accomplished by extending credit to customers. The timing of accounts receivable collection is a major focus in cash management. 4. Collection of receipts. Only when the customer has provided good funds for the merchandise or service does the cash flow cycle conclude for that transaction. The cash flow and operating cycles are similar. The cash manager focuses on the timing of the cash flows related to accounts payable, accounts receivable and inventory turnover. Operations managers concentrate on the timely availability of materials and resources and on sales volumes, relying on the cash manager to ensure adequate liquidity to support operations. Cash forecasting is based on understanding both the Operating and the Cash Flow cycles. Page 6

7 Operating Cycle 1. Material Purchases 4. Collection of sales receipts 4. Collection of sales receipts 1. Material Purchases Cash Flow Timeline 2. Payment for resources 3. Sale of Inventory 3. Sale of Inventory 2. Convert Material to Goods for Sale Cash flow versus business operations cycles Float: The most critical component in Cash Management Float is the time interval between the start and completion of each step in the cash management cycle. The management of float is the management of cash. Each cash management system is designed to improve the flow of cash by accelerating the collection of funds and extending the disbursement float. There are two categories of Float: Collection Float and Disbursement Float, each with several components. Collection Float is the time spent to collect receivables. Collection float is the sum total of time taken by the following four components: 1. Invoicing float is the time period between the delivery of goods or services to the customer and the customer s receipt of the bill, generally by mail. It is the time it takes a company to record its delivery of service or goods and then to produce and mail a bill. Typically, the cash manager has little control over this function, although it is generally the Collection Float component with the longest duration. Cash managers have focused almost exclusively on the remaining three components. 2. Mail float is the time it takes the U.S. Postal Service to deliver the customer s payment. 3. Processing float is the period between the receipt of the payment and its deposit into the company s bank account and includes the time it takes to record the payment in the accounting system. 4. Availability float is the time it takes the deposited check to clear the customer s account and for good funds to be available to the company for disbursement. As early as 1947, RCA set up a lockbox collection arrangement to accelerate the receipt and processing of payments. The objective was to shorten the float for mail, processing, and availability. Current lockbox services and products still concentrate on these areas. Disbursement Float is the time it takes a company s payment to be created, mailed, received, deposited and presented to the drawee bank for settlement. Thus collection float and disbursement float refer to the same processes and time intervals depending on point of view: For the company receiving a payment, collection float represents the time it takes an invoice to be prepared, to reach the customer, to receive payment and for the payment to clear the bank. Page 7

8 For the company making the payment, that same interval is disbursement float. Disbursement float consists of the following four components: 1. Invoicing and payment processing float includes both the time it takes the supplier to prepare and send the invoice, as well as the time the accounts payable department requires to process the invoice and create the payment. 2. Mail float is the time it takes the U.S. Postal Service to deliver the payment to the vendor. 3. Processing float is the time it takes the vendor to record the payment and deposit it into the bank. 4. Availability float is the time it takes the bank to clear the check and deduct the funds from the payee s bank balance. Cash management focuses on shortening collection float and extending disbursement float, tempered by maintaining positive customer and vendor relationships. The skillful management of float contributes real bottom-line impact and benefit to the company. This financial result is measured by a simple mathematical formula: [Float dollars] x [time] x [interest rate earned or paid] = monetary benefit. Components of Float Purchase & Pay Accounts Payable Float Payment Float Disbursement Float Purchase Made Invoice Received Payment Mailed Payment Received Check Deposited Funds Debited Sell & Collect Accounts Receivable Float Collection Float Invoice Float Make Sale Send Invoice Invoice Received Payment Sent Payment Received Check Deposited Funds Available Page 8

9 How does money move? Money moves in three ways: (1) exchange of currency, (2) presentation of a paper item or (3) electronic transaction. Cash may be common for small purchases of goods and services, but checks and electronic transfers are used almost exclusively in most business environments. In spite of the growth of electronic payments, paper checks account for the majority of business transactions. Electronic payments, while much lower in total transaction volume, are significantly higher in dollar value with the exception of direct deposit payroll. Cash managers monitor and often initiate both electronic and paper transactions through the use of cash management services provided by banks. Effective use of these services results in better control and use of corporate funds. Several types of services are discussed later. Paper Transactions Paper transactions consist of checks or drafts that transfer value from the payor to the payee. Each bank accepting checks for deposit (depository bank) must, in turn, collect funds from the bank that holds the check maker s Paper Transactions Payor s Check US Postal Service Payee Company Payor s Bank Regional Fed Local Fed Local Clearinghouse Direct send to Correspondent deposits (drawee bank). This is accomplished by physically presenting the check for payment. Pilot studies have been conducted in check truncation. The process electronically captures data from the check s MICR line (which contains bank transit routing number, account number and dollar amount) and sends the information to the drawee bank for same day settlement of funds. The physical checks are either destroyed or delivered to the drawee bank via a more leisurely route. Despite the pilot efforts, the U.S. banking system still requires physical check presentment for funds settlement. Paper items are collected in many ways, but most commonly in one of the following three: (1) through the Federal Reserve System, (2) through the Local Clearinghouse, or (3) by directly sending checks to Correspondent Banks. Checks deposited into the same bank on which they are drawn, referred to as on-us, are cleared within the bank with simultaneous debits and credits to the payor and payee s accounts. Checks may be presented to any of the Federal Reserve processing centers for clearing to any other U.S. financial institution. The Federal Reserve, in turn, transports and presents the checks to the drawee financial institution. To collect through the Federal Reserve network, the depository bank delivers a cash letter to one of the Federal Reserve s 48 check processing centers. A cash letter is a batch of checks accompanied by adding machine tapes and a summary document that includes the total dollar deposit. Banks may deliver cash letters directly to several different Federal Reserve geographic locations in order to expedite the settlement of funds. Local Clearinghouse Associations exist throughout the U.S. for the purpose of exchanging checks drawn on local member banks. Each member bundles checks for exchange and delivers these Payee s Bank bundles to other members at designated times throughout the day. At the last exchange of the day, net Page 9

10 settlement amounts are computed and payments are made through the Fed accounts of each member bank. Delivering a cash letter directly to a Correspondent bank outside the local area is commonly referred to as direct sending. The cash letter may contain items drawn solely on the receiving Correspondent bank. It may also include items the Correspondent bank will clear as agent for the sending bank. Cash management banks focus significant effort on improving the speed with which they are able to clear their customers deposits and typically use all of the above three methods to collect funds. Each method yields different availability schedules and has related costs. To achieve aggressive availability, the cash manager must be prepared to sometimes pay a premium for banking services. Electronic Transactions Electronic transactions do not rely on paper to move money. There are two types of electronic transfers in the U.S. banking system: (1) wire transfers using the Federal Reserve s Fed wire system and (2) Automated Clearing House (ACH) items. Both methods are referred to as electronic funds transfer (EFT) transactions. EFT is the transmission of an electronic message to a depository financial institution requesting that funds be transferred from one depository account to another account. International transactions between major U.S. and foreign banks typically use the Clearing House Interbank Payments Company (CHIPS) for electronic, end-of-day settlement of funds. The Society for Worldwide Interbank Financial Telecommunications (SWIFT) is a network that carries instructions to move money internationally, but does not directly settle funds. Instead, each member is responsible for arranging funds transfers, generally through their correspondent banks. Fed wire transfers settle through the Federal Reserve Bank. These are real-time transactions in which the Federal Reserve accounts of the payee and payor financial institutions are simultaneously settled. Immediately upon receiving instructions from the payor institution, the Fed reduces the payor s account and increases the payee account by a like amount. Once the Federal Reserve Bank books the debit and credit entry that transfers value, the transaction is irrevocable. Each completed transfer is assigned a Fed wire number by which the payment can be traced to the payee s account and confirmed. Wire transfers are the most expensive method of payment. For that reason, they are typically only used when a company requires an immediate and final settlement of funds, such as in a purchase of real estate. Fed Wire Sending Bank s Fed Wire Room Electronic Message to Fed Federal Reserve A $ B Electronic Notification of Deposit Receiving Bank s Fed Wire Room A - Sending Bank s Fed Account B Receiving Bank s Fed Account Page 10

11 ACH Funds Movement Originating Company Originating Bank Local ACH National ACH (NACHA) Receiving Bank Credit or Debit to Receiver s Bank Account Automated Clearing House (ACH) transactions operate according to rules and guidelines promulgated by the not-for-profit National Automated Clearing House Association (NACHA). ACH transactions are most widely known as the means by which direct deposit payroll is settled. ACH payments may, however, be set up to either debit or credit the originating company s account. For this reason, the terms payee and payor are not used in describing ACH transactions. The parties instead are referred to as the originator or the recipient and a transaction is described as either an ACH credit or an ACH debit. ACH credit transactions move funds from the originator s account to the receiver s account while ACH debit transactions move funds from the receiver s account to the originator s account. For example, with a direct deposit payroll transaction, the originator is the employer, the recipient is the employee and the transaction type is an ACH credit. In the instance of a utility company collecting payments on a monthly basis from its customers, the utility company is again the originator, the customer is the recipient but the transaction type is an ACH debit. A company may initiate a single ACH transaction, but typically the ACH process is used as a batch process permitting thousands of ACH transactions to occur at the same time at a low cost per transaction. As a batch process, ACH transactions do not settle immediately and simultaneously as Fed wire transfers do. ACH credit transfers for payroll direct deposit, for example, must be originated at least two business days prior to the settlement (value) date. Under NACHA guidelines, there are specified circumstances that permit the return of the ACH debits and credits. Unlike Fed wire transactions, payments made through the ACH network are neither immediately settled nor irrevocable. Page 11

12 How are Cash Management Systems established? For funds management to be as efficient as possible, the flow of funds must be accomplished as passively as possible. In establishing the corporate bank account configuration, the focus should facilitate the automated movement of funds. Separate accounts are established for different business functions: payroll, retail outlets depository accounts, accounts payable disbursements, and lockbox receipts. By maintaining separate accounts, account reconciliation to the general ledger balance is accomplished more easily and in some cases, can become an automated daily process. Fraudulent activity and unauthorized transactions are more readily apparent and detected with less effort, improving overall audit trails and internal control. The master (or concentration) account is the central point through which all corporate funds move and from which corporate liquidity is centrally managed. After the initial deposit of receipts, funds should automatically move into the master account. Moving available balances to a single account eliminates small, idle balances. From a master account, funds can be used to pay down debt, cover payments, and invest. Without the use of a central master account, determining daily cash requirements and forecasting the short term cash position would be significantly more complex. Mobilizing the funds needed to cover daily cash movements would require numerous transfers and intensive human effort to keep the funds flowing as needed day in and day out. Collection and concentration services are offered to convert a company s receipts and receivables into available operating capital, that is, cash on hand. These services are designed to minimize certain components of float and concentration funds into one main, or master, account. From the master account, the cash manager can determine cash on hand to cover the daily clearing of checks, scheduled debt service or dividend payments and short-term investments. To process and deposit payments received by mail, a lockbox service can be contracted with a bank or third party vendor. A lockbox service processes payments received through the mail. Customers are instructed to mail their payments to a special post office box address. The bank arranges to pick up the mail several times a day and take it immediately to the area where the payments are processed and the checks deposited. Customer account numbers and payment amount information is forwarded to the company to update its accounts receivable system. Because payments are received directly by the bank, the deposit and collection of funds are expedited. There are two basic types of lockboxes: wholesale and retail. Wholesale lockboxes process a relatively small volume of large dollar payments that are typically accompanied by numerous and varied payment documents, such as the payor s purchasing documents, a listing of multiple invoices being paid or detail information referencing contract numbers and voucher data. A copy of the check is made and matched with the documents received with the payment. Payments are endorsed, batched and deposited by the bank s lockbox area. The primary advantage of a wholesale lockbox is the acceleration of the collection of funds for these large dollar checks. The company does the update of the customers accounts from the check copy and documents delivered to the company by the bank. It is a manual process. Retail lockbox services handle a high volume of payments, generally of a small dollar amount. Examples of payments processed in a retail lockbox environment include utility payments, gasoline credit card payments, magazine subscriptions and consumer loan payments. Retail lockbox processing relies on high-speed equipment to electronically read the check and customer account information. Customers making payments through a retail lockbox are provided with a remittance document or payment coupon, which they are asked to return with their payment. This remittance document contains account information usually in some sort of scannable format, such as a bar code, from which the bank is able to capture information electronically. Generally the company requests the payment and account information be received from the bank as an electronic file for upload directly into its receivable system. Page 12

13 A company s specific lockbox arrangements can be customized by contractual arrangement. These lockboxes may be referred to as custom retail, wholetail or a similar designation. There are also electronic lockbox services being developed for the receipt of ACH, credit card and other non-paper payments. Deposit consolidation or Cash concentration becomes more challenging when there are several retail establishments, corporate divisions or branches that span a wide geographic area. Retail and branch depository services typically consist of numerous bank accounts spread over several states, or even worldwide in order to be conveniently located for prompt deposit of receipts. Security and employee safety may also be considered in selecting a local bank, although these factors are mitigated if an armored courier service is used to pick up deposits at the sites. For the cash manager, however, the focus remains on concentrating the funds from accounts throughout this network of retail depository banks quickly and efficiently. Non-retail corporations or organizations may also have depository accounts throughout the country. It is not uncommon for corporate divisions and branches to accept payments directly and track their collections and disbursements independently. The cash manager may be required to separately identify each division s cash flow for reporting, forecasting and control purposes. To optimize cash liquidity and to use working capital most efficiently, these various sources of funds must be moved into the master concentration account and managed on a corporate level. Imagine each division or store managing its own pool of funds. Without the benefit of centrally managed cash, each entity would be required to borrow or invest as its individual needs dictated, irrespective of the overall corporate cash position. Centralized cash management can track the cash position of each unit, providing inter-company loans to support operations, capital improvements and expansions and investing pooled surplus funds at a higher rate of return. Borrowing done on a corporate-wide basis is typically more favorably priced and easily available. If the corporation elects to issue commercial paper or corporate bonds, it is essential to manage these programs centrally. The movement of funds from a division or store s account to the concentration account can be accomplished in several ways. If division deposits are made into a branch of the concentration account bank, divisions may be provided with deposit slips directing the money into the concentration account. A zero balance account (ZBA) or similar arrangement can be established which results in account balances being moved to the concentration account at close of business each banking day. If the depository bank is not the same bank that holds the concentration account, funds are transferred one of three ways: (1) paper check (2) ACH or (3) Fed wire. A paper check, known as a Depository Transfer Check (DTC), is created and deposited into the concentration account. A typical corporate system may designate an internal clerk or contract with a third party administrator to accept a daily phone call or an electronic report from each division or retail outlet reporting the day s deposits. The corporation then creates a DTC for each depository account and deposits it into the concentration account. A third party administrator may also collect the divisions reports and create a file to transmit to the concentration bank. The file includes the relevant deposit account information and amount for each site and requests that a DTC be created for deposit to the concentration account. This method may also be used to request ACH transfers. ACH transactions are the least costly method of moving funds. ACH transfers may be initiated via an on-line banking system or by direct file transmission. One possible scenario would be requesting daily electronic reports of deposit amount from each division, either by or entered directly into a database. This data would then be forwarded to the bank for processing as a batch ACH file. As ACHs may be either debits or credits, it is also possible for each division to initiate an individual ACH credit moving the funds from the local to the concentration account. Wire transfers are the most costly method of moving money. A wire transfer would not typically be used as a daily cash concentration mechanism. However, for very large deposits, a wire transfer ensures same day settlement of funds into the concentration account. Only funds that are immediately available (that is, zero float) may be transferred by Fed wire. Disbursement Accounts are established to enable Page 13

14 a company to know what has been paid and when cash is needed to cover those payments. As discussed below, separate disbursement accounts also improve control and protection of funds and expedite reconciliation. Disbursement systems typically consist of at least one account for vendor payments and one for payroll. If the corporation has more than one division, it may wish to track expenditures and payroll separately for each entity. This may be accomplished by (1) opening additional bank accounts or (2) structuring a multi-tiered (subaccount) system. Multi-tiered arrangements permit (a) centralized management by using one parent disbursement account for funding all payments, (b) division by division tracking by using a subsidiary account of the parent for each division, and (c) reduced banking fees. Disbursement services developed, in part, as an attempt to extend clearing float. The Fed has, however, significantly reduced this float over the years. As a result, disbursement accounts today are designed primarily to assist a company in controlling, funding and reconciling payments. Zero Balance Accounts (ZBA) are designed to move all excess balances from depository accounts into a single master or cash concentration account and to fund all disbursements accounts from the master account. Transfers are made automatically, with all individual accounts maintaining a constant Example of a Simple Company Structure Overnight Investment Concentration and Depository Account $ Payroll Accounts Payable Example of a Complex Company Structure Lockbox 1 Depository Account Payroll Salary Lockbox 2 Depository Account Lockbox 3 Depository Account $ Concentration Account $ Payroll Hourly Accounts Payable Retail Depository $ Health Insurance Claims Delinquent Collections Depository Overnight Investment Sweep Account Petty Cash Page 14

15 zero balance. During the day, deposits and disbursements are made to and from the individual zero balance accounts. This tracks the funds by division, function or other structure as defined by the company in setting up the accounts. At the end of the banking day, transfers are made to move funds into and out of the master account in the amounts necessary to create a zero balance in each individual account linked to the master account. The use of a ZBA account structure lets a company track individual subsidiary operations while allowing those subsidiaries to function independently. This system allows centralized control of available cash on a daily basis. Controlled Disbursement Accounts provide even greater control and knowledge of the daily cash flow. Controlled disbursement permits a company to know on a current day basis how much funding will be required to cover payments presented for settlement. The total dollar value is available early in the day, allowing the company the necessary time to invest or liquidate funds or to borrow money on a same day basis to cover cash shortfalls. Controlled disbursement accounts are structured to receive presentment of checks to be paid (via the cash letter) on a current day basis only from the Federal Reserve Bank. No checks on these accounts are accepted through local clearinghouses or as direct sends. Funding is immediate, usually via Fed wire, which keeps the controlled disbursement account balance at zero. In addition to the special disbursing accounts described above, most cash management banks offer additional services to reconcile these accounts, enhanced methods to protect against fraud and complete disbursement outsourcing solutions. Partial and Full Reconciliation Services provide reports of sequentially numbered paid items in either a paper or electronic format. With Partial Reconciliation, the company compares the list of checks paid with the list of the checks it issued to produce a list of outstanding checks. Full Reconciliation services involve the company providing a file of all issued checks to the bank. The bank matches the checks paid against the checks issued and generates an outstanding check file for the company. Positive Pay is a cash management service to assist in detecting and preventing check fraud. With this arrangement, the company provides the bank with timely and complete files of all issued checks. The bank compares the items presented for payment against the check issued file. If the item does not match the amount or a check number on the issue file, it is flagged as a suspicious item and the company is immediately notified. The bank will ask the company to make a pay or no pay decision on the item. The majority of suspicious items result from a delay in notifying the bank about issued items; however, counterfeit, stolen check stock and altered checks will all be detected in this process, and significant losses can be averted. Accounts Payable Outsourcing simply shifts the task of issuing payments to the bank. A file of payments to be made is extracted from the accounts payable system and sent to the bank or a third party vendor. The file may designate if the vendor is to be paid by check or electronically. The bank initiates payment according to the information provided on the file. How is information about money movement tracked and recorded? Once a company has established the bank account structure and cash management services it determines are appropriate for its operations, it needs a method of monitoring and forecasting its daily cash flows. Maintaining the necessary liquidity on a daily basis requires forecasting, tracking, borrowing and investing activities. Typically, a daily target balance is selected and funds are managed to that goal. Meeting the target balance depends on accurate and timely information about day-to-day receipts and disbursements plus any banking requirements for a compensating balance. Managing to that goal requires skillful cash forecasting, the availability of a borrowing facility and/or attractive short-term investment opportunities. Information Reporting Systems are the Page 15

16 principal and initial source of cash management information. As noted in the discussion on the account structure, the concentration, or master, bank account serves as the company s clearinghouse and control point for all cash flow. On a daily basis, the cash management bank provides a balance report. This report includes not only the ending balances for the prior business day, but an analysis of that balance with respect to its deposit float, or the uncollected, and thus unavailable, portion of the funds. Also provided are all transactions for the prior day, including wire transfer details, deposit consolidation, investment purchases and maturities and all other activity moving through the concentration account. This report is typically retrieved on-line using a personal computer and proprietary banking software requiring various security layers of password protection, depending on the nature of the system access. Comparing the prior day s activity reported by the bank to the company s record of transactions and forecasted activity establishes a substantial control procedure. Daily reconciliation immediately identifies unauthorized electronic transfers, posting errors and other irregular activity. Coupled with positive pay services for the protection of payments made by check, the daily reconciliation process is the most effective means of identifying fraudulent activity. 1 In addition to retrieving the prior day activity and closing balances, major cash management banks provide on-line, intra-day transaction reporting. These reports include current day lockbox deposits, incoming and outgoing wires, controlled disbursement cash letter amounts and provisional credit for ACH transactions scheduled to settle at the close of business. Designing an organized and efficient method of using this information daily is a major challenge facing all cash managers. Information must be retrieved, summarized, tracked and analyzed. Forecasting short-term cash flows of receipts and disbursements is an essential cash management function. Tracking the forecasted cash transactions to the actual is a daily task to validate the accuracy of the forecast. In order to complete these daily tasks on a timely basis, cash managers frequently develop spreadsheet applications. If the manager is dealing with many banks and a large number of bank accounts, spreadsheet solutions may not be adequate. Treasury Workstations (TWS), sometimes called Treasury Information Management Systems (TIMS) are software modules that automate many of the cash manager s information collection, monitoring and analysis tasks. These systems may be purchased from software vendors for prices varying widely and sometimes moving well into the six-figure range. Banks have previously developed TWS software products for their customers, but in recent years most have discontinued this service. Companies with sophisticated information technology (IT) resources may develop proprietary software. Because TWS are database programs, they are frequently interfaced with the company s general ledger for automation of treasury journal entry posting. The banking systems developed for information reporting also permit certain transactions to be completed on-line. Wire transfers, direct deposit payroll transmissions, stop payment orders and foreign currency purchases are examples of the types of on-line services most cash management banks provide. Why is Bank Relationship Management Important? A company s relationship with its banks is much more complex than the typical vendor relationship. Banks are the source of working capital, custodian of a company s liquid assets, and a critical reference polled by major suppliers and credit rating agencies, such as Dun & Bradstreet. The services available to a company and the costs of those services depend on a favorable assessment by the bank of the company s financial stability. In turn, the bank s financial position must be monitored by the company to avoid the disastrous 1 Under the current Uniform Commercial Code, a company may be questioned as to its daily reconciliation procedures to determine if there is contributory negligence in the event of a loss. Page 16

17 consequences following a bank failure. To a lesser degree, changes in bank management, or exiting certain markets, such as credit card processing, can also create hardships for companies caught off guard. A productive and beneficial banking relationship is based on good communication, mutual trust and respect and confidence in the stability and financial health of each party. Open and frequent communication is the keystone for building the relationship. Banks dislike surprises of any sort; surprises undermine the company s credibility and cause concern about the company s candidness. Large companies generally hold regular meetings for its bankers, providing financial statements, discussing upcoming plans, such as acquisitions or downsizing, and identifying future banking services and financing needed to support the plans. Initially the company should apprise the banks of its cash management practices, bank account structure and expectations regarding the bank s performance. On an on-going basis, the company should immediately address any operating problems or banking errors. A mechanism, such as bank report cards, may be used to provide timely feedback about the quality of banking services. It is important to recognize that the bank is entitled to fair compensation for services rendered. A relationship based on constant pressure to reduce or eliminate fees is not a good one and is likely to terminate at an inopportune moment. Banking fees have been subject to the pressure of competition over the past several years. As a result, many banks have merged or exited cash management and other corporate service markets. may result in better pricing, if the business is of a significant size for the bank. The company may also enjoy more attention and support from the bank than its smaller customers do. However, by dealing with only one bank, the company may risk hardship in the event of a bank merger or a major shift in the bank s market focus. Bank Fees As noted, fair compensation for services provided is an important factor in the banking relationship. Banks are compensated in three ways: (1) interest on credit services, (2) fees and (3) compensating bank balances. 2 A company may use all three as a means of paying for services received. The cash management bank produces an account analysis statement monthly. This statement is essentially an invoice describing the types and volume of transactions for the period, the fees for those services and an earnings analysis for the average deposit balance in the account. The imputed income from the deposits (less the uncollected funds and a 10% reserve requirement) is deducted from the fees charged to determine the amount, if any, owed to the bank for services received that month. A cash manager will evaluate multiple factors in selecting the method of compensation. He or she will weigh the opportunity cost of leaving funds on deposit to cover banking fees. There may be relationship considerations that favor compensating balances, such as more favorable credit terms. Use of compensating balances eliminates banking fees from the income statement. The cash manager must consider the availability, quality and costs of banking services in developing an appropriate banking strategy for the company. A crucial decision is whether to spread business among several financial institutions or to concentrate business in one bank. Concentrating all business in one bank 2 Under banking Regulation Q, interest cannot be paid on corporate demand deposit accounts; however, this Regulation is under review for repeal. Page 17

18 How is surplus cash invested? The method of performance measurement or benchmark guidelines Surplus cash can arise from many sources: the sale of stock, loan proceeds, seasonal sales peaks, growth of earnings and simply the acceleration of the cash flow cycle. If the company has outstanding debt, especially a short-term working capital credit facility, the manager may elect to pay down the liability. If, however, the cash surplus is temporary, the cash manager may want to invest in short-term, money market instruments. There are three areas that need to be defined in any investment strategy and should be clearly spelled out in all investment policies: (1) risk tolerance (protection of principal), (2) liquidity and (3) return. These factors are listed in order of priority. The preservation of principal is a serious consideration in the selection of an investment. Although there is some degree of risk in all investments, that risk is identifiable and may be controlled. The capable manager will choose investments that offer both income and the safety of principal. Cash management s primary objective in holding short-term investments is to maintain adequate liquidity: assurance that investments can be easily sold prior to maturity to cover unexpected cash shortfalls. The investment strategy for short-term holdings is to maintain an adequate liquidity reserve (or cushion ) while increasing interest income. Investment Policy Most companies recognize the importance of establishing an investment policy. The policy spells out who has investment authority and how that authority is to be carried out and monitored. The policy typically specifies: The types and quality of investments permitted The qualifications and standards for dealers and issuers from which investments are purchased The maturity and diversification guidelines The custodian requirements for holding securities and Money Market Instruments Short-term securities vary widely in credit quality, negotiability, yield and maturity. The market for debt and equity instruments consists of (1) the short-term money market in which short-term fixed income and debt securities are traded and (2) the longer-term capital market. Cash management focuses on the former the money market. The money market is a group of markets selling debt instruments that mature in one year or less. Money market securities include: U.S. Treasury securities are issued by the U.S. government to finance its activities and are considered relatively risk-free. The secondary market is enormous and thus these securities are considered the most liquid. Municipal obligations are debt instruments issued by state and local governments and agencies. These are typically tax-free. Federal Agency securities have some degree of federal government backing. Agency issues are typically smaller than Treasury securities, but are similar in liquidity and trade at a higher yield than Treasuries of the same maturity. Federal Agency issuers include Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Association), Federal Home Loan Bank, and Federal Farm Credit Banks Funding Corporation among others. Bank Financial Instruments include domestic and foreign bank short-term certificates of deposit, time deposits, bank notes and banker s acceptances (BAs). Commercial Paper (CP) is an unsecured promissory note issued by a corporation for a specific amount and a specified period of time, not to exceed 270 days. It may bear an interest rate but is typically sold at a discount. Commercial paper is rated by credit rating agencies. Repurchase agreements (repos) are collateralized transactions between a securities dealer and an investor. The investor Page 18

19 purchases a security with an agreement to sell it back to the dealer at a future date. Most securities used are U.S. Treasury or agency securities. There are also professionally managed Money Market Mutual Funds that consist of marketable securities. These funds typically offer diversified portfolios with competitive yields. Money Market Mutual Funds are an excellent investment choice for companies with limited personnel or investment skill. How are cash shortages managed? Unused borrowing capacity is a liquidity management tool. As the old adage says, the best time to borrow money is when you don t need it. Defining the amount of a short-term line of credit requires not only a reliable cash forecast, but also a thorough understanding of seasonal revenue fluctuations, timing of major capital expenditures, the intra-period timing of receipts and disbursements and an appropriate contingency factor to deal with the unexpected. The objectives in establishing borrowing levels are to: Ensure adequate funds to meet short-term cash requirements Minimize the cost of funds Avoid an excessive debt burden or a potential default Develop alternative sources of short-term borrowing to maximize flexibility and the responsiveness to sudden market shifts and opportunities There are numerous arrangements and methods for managing temporary cash shortfalls. Each company has to determine the best method available to them to obtain short-term financing, based on its overall financial health and strategic financial planning. The cost of short-term borrowing is determined by the lender s perceived credit risk that is established by reviewing the borrower s current earnings, leverage, future growth potential and the type of collateral, if any, securing the debt. Short-term financing alternatives include: Line of Credit is an agreement between the lender and the borrower that allows the borrower to access funds up to a maximum amount. Commercial Paper (CP) is debt that is issued directly by the company or through its dealers. It is an unsecured promissory note for a specific period of time and is generally issued at a discount. The cost of credit via commercial paper issuance depends on the credit worthiness of the company. Companies issue CP to obtain cheaper, more flexible or more available financing than is offered through financial institutions. Reverse Repurchase Agreements (reverse repos) involve a company holding short-term investments selling securities to a dealer with the agreement to buy them back at specific price and time. In essence, the company is borrowing money from the dealer and offering the securities as collateral. Asset-Based Borrowing is a form of secured lending based on pledging corporate assets as collateral. The most common form of assetbased borrowing is the pledging of accounts receivable, but also may involve collateralizing inventory, real estate (mortgage) or other tangible property. Factoring is the sale of a title to accounts receivable to a third party (factor) at a discounted rate. Securitization is a financing method in which a company issues debt securities backed by a pool of selected assets, such as receivables, equipment leases or auto loans. The assets have a predictable cash flow stream, which provides the resource for retiring the debt securities. Trade Credit cannot be overlooked as a means of short-term borrowing. Some vendors offer substantial trade discounts for early payment. Delaying payment for the full payment terms, Page 19

20 however, can be a source of short-term cash. Economically, however, missing trade discounts tends to be the most expensive method of short-term borrowing. Late payments create significant vendor relationship problems and will ultimately impair the company s access to credit. Does International Cash Management differ significantly from the U.S.? The international cash management market is becoming an important focus as the economy goes global. The objectives and issues of international cash management are similar to domestic cash management. The same theories of efficient collection of funds and information about funds movement apply in the international market. There are, however, additional challenges and issues in managing foreign exchange, cross-border funds movement and the volatility of the global financial environment. Social and cultural differences vary widely from U.S. practices and from country to country. A myriad of differences exist in foreign and domestic tax rules, payment systems, government regulations and restrictions on cross-border funds and data exchange. While the cash management objectives remain constant globally, the means by which they are accomplished vary greatly. The centralization of international cash management is a trend which has been accelerated by developments in the European economic and monetary union and the technological multi-currency reporting capabilities of enterprise resource planning (ERP) software programs such as SAP, Oracle and PeopleSoft. While global centralization of local receipts and disbursements may not be feasible, there are several functions that can be and should be managed globally. A centralized treasury management operation may establish global practices and policies for treasury operations such as banking service selection, internal control and reporting policies. Guidelines for international transactions, such as purchase of foreign currency, exposure hedging and settlement of inter-company commerce are also generally defined on a global level. Centralization of global cash management is most effectively implemented in managing intracompany funding, netting of payables and receivables, investments, and foreign currency exposure. In order for centralized management to accomplish its objective, however, a great deal of effort and skill is required to prepare a forecast and analysis of international cash flows. Though a complex and sometimes difficult task, it is critical if the company is to minimize foreign currency losses, excessive taxation and substantial profit erosion due to a lack of overall risk management strategy. What resources are available to learn more about Cash Management? As corporate treasury departments expand, there are new areas of responsibility thrust upon the cash manager. Often the department lacks the personnel or knowledge to implement senior management initiatives or effectively and smoothly incorporate policy changes and systems accompanying bank mergers. When a company expands into an international market, it become necessary to manage foreign currency exposure. Acquisitions, mergers and divestitures all result in changes to cash management procedures and bank account structures. Customer growth or operational changes and attrition may exceed the ability of staff to process payments. One of a cash manager s first and most important resources is his or her banker. As discussed in the section on banking relationships, keeping your banker fully informed and up to date on the company s plans and significant events allows the banker to introduce services and solutions consistent with the company s changing needs. There are a number of books, websites, periodicals and seminars addressing all areas of treasury and cash management. Several are included in the Appendix. Page 20