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ELECTRONIC FUNDS TRANSFER

Many cash payments involve pieces of paper, such as dollar bills or a check. But the use of paper transactions is on the decline. For consumers, paper is being replaced by credit cards or debit cards. In the case of companies, payments are increasingly made electronically. When banks in the United States make large payments to each other, they do so electronically, using an arrangement known as Fedwire. This is operated by the Federal Reserve system and connects more than 10,000 financial institutions in the United States to the Fed and so to each other. Suppose Bank A instructs the Fed to transfer $1 million from its account with the Fed to the account of Bank B. Bank A`s account is then reduced by $1 million immediately and Bank B`s account is increased at the same time.

Fed wire is used to make high-value payments. Bulk payments such as wages, dividends, and payments to suppliers generally travel through the Automated Clearinghouse (ACH) system and take 2 to 3 days. In this case the company simply needs to provide a computer file of instructions to its bank, which then debits the corporation`s account and forwards the payments to the ACH system.

For companies that are ¬wired ­ to their banks, these electronic payment systems have several advantages:

І Record keeping and routine transactions are easy to automate when money moves electronically. For example, the Campbell Soup Company discovered it could handle cash management and short-term borrowing and lending with a total staff of seven.3 The company`s domestic cash flow was about $5 billion.

І The marginal cost of transactions is very low. For example, it costs less than $10 to transfer huge sums of money using Fedwire and only a few cents to make each ACH transfer.

І Float is drastically reduced. This can generate substantial savings. For example, cash managers at Occidental Petroleum found that one plant was paying out about $8 million per month several days early to avoid any risk of late fees if checks were delayed in the mail. The solution was obvious: The plant`s managers switched to paying large bills electronically; that way they could ensure checks arrived exactly on time.4

Inventories and Cash Balances

So far we have focused on managing the flow of cash efficiently. We have seen how efficient float management can improve a firm`s income and its net worth. Now we turn to the management of the stock of cash that a firm chooses to keep on hand and ask: How much cash does it make sense for a firm to hold?

Recall that cash management involves a trade-off. If the cash were invested in securities, it would earn interest. On the other hand, you can`t use securities to pay the firm`s bills. If you had to sell those securities every time you needed to pay a bill, you would incur heavy transactions costs. The art of cash management is to balance these costs and benefits.

If that seems more easily said than done, you may be comforted to know that production managers must make a similar trade-off. Ask yourself why they carry inventories of raw materials, work in progress, and finished goods. They are not obliged to carry these inventories; for example, they could simply buy materials day by day, as needed. But then they would pay higher prices for ordering in small lots, and they would risk production delays if the materials were not delivered on time. That is why they order more than the firm`s immediate needs. Similarly, the firm holds inventories of finished goods to avoid the risk of running out of product and losing a sale because it cannot fill an order.

But there are costs to holding inventories: money tied up in inventories does not earn interest; storage and insurance must be paid for; and often there is spoilage and deterioration. Production managers must try to strike a sensible balance between the costs of holding too little inventory and those of holding too much. In this sense, cash is just another raw material you need for production. There are costs to keeping an excessive inventory of cash (the lost interest) and costs to keeping too small an inventory (the cost of repeated sales of securities).