Custom Search

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.

Float

Suppose that your firm writes checks worth $6,000 per day. It may take 3 days to mail these checks to your suppliers, who then take a day to process the checks and deposit them with their bank. Finally, it may be a further 3 days before the supplier`s bank sends the check to your bank, which then debits your account. The total delay is 7 days and the payment float is 7 Р РЈР Р· $6,000 = $42,000. On average, the available balance at the bank will be $42,000 more than is shown in your firm`s ledger.

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 interestearning 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 Р РЈР Р· $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.