Collection Float: Example and Ways to Reduce it
Understanding collection float:
There is often a time lag between the receipt or issuance of cheques by a business and the actual processing of them by the bank. That is why entries made in the books may not represent the actual balance available at the bank.
Float refers to the difference between your cash balance as per books and the actual available cash. It reflects the net effect of cheques that are pending in the process of clearing. This is a broad definition of float but it can have different meanings depending on the industry you are in.
Commonly, Float = Firm’s Available Balance – Firm’s Book Balance
What are the items affecting float?
Float is typically affected by the following items:
- Mailing time
- Cheque Processing delay
- Bank’s Availability delay
Disbursement float and collection float
Float is normally of two types:
1. Disbursement float
Disbursement float arises when your firm writes and issues a cheque to its creditors and suppliers, etc. When you issue a cheque, what happens is that your book balance decreases but there is no change in its available balance. Since the processing and clearing of the cheque involves a certain time period, it causes a difference between the book cash and the available cash. This is called disbursement float.
Assume ABC Company has a book balance of Rs. 4 Lac as well as an available balance of Rs. 4 Lac with its bank, State Bank of India, as of March 31. On April 1, it sends a cheque for Rs. 1 lac to one of its suppliers, reducing its book balance by Rs. 1 lac. The State Bank of India, on the other hand, will not debit ABC Company’s account until the cheque is presented for payment on, say, April 6. Until that happens, the firm’s available balance is Rs. 1 lac higher than its book balance. As a result, ABC Company has a disbursement float of Rs. 1 Lac between April 1 and April 6.
Disbursement Float = Firm’s Available Balance – Firm’s Book Balance = Rs. 4 Lac – Rs. 3 Lac = Rs. 1 Lac
2. Collection float
Collection float, on the other hand, arises when your firm receives a cheque from its customers or parties who owe money to your business. When you receive a cheque, your bank balance does not get immediately increased. There is always a time gap involved in the clearance of cheques. This again causes your book balance of cash to differ from your actual available balance. On receipt of cheques, your book balance increases but there is no change in its available balance. This is called collection float.
For instance, assume XYZ Company has both a book balance and an available balance of Rs. 5 Lac as of April 30. On May 1, XYZ Company receives a cheque for Rs. 1.5 Lac from one of its customers, which it deposits in the bank. It immediately increases its book balance by Rs. 1.5 lac. This sum, however, is not available to XYZ Company until its bank presents the cheque to the customer’s bank on, say, May 5. Therefore, between May 1 and May 5, XYZ Company has a collection float of (Minus) Rs. 1.5 Lac.
Collection Float = Firm’s Available Balance – Firm’s Book Balance = Rs. 5.0 Lac – Rs. 6.5 Lac = (-) Rs. 1.5 Lac.
Note:
There is yet another concept called net float. The net float is the difference between the disbursement and collection floats. This value may be considered by an organization in order to understand how its funds may change once all sent and received cheques have been processed completely.
Definition of collection float
When it comes to collections receivable by a firm from its customers, float signifies the sum which is on hold but that the firm owns. In other words, the sums that travel through your customers but are still to reach your bank account signify the “collection float”.
What is the cost of float?
Simply put, the cost of collection float is the opportunity cost of not having that money in cash. At the very least, if that money had been available for investing, the firm could have earned interest on the same.
The future of float (Electronic data interchange)
With the increasing popularity and growth of electronic banking, transfers, payments, and so on, it is possible that float could soon become a non-influencing item. If the business world continues to develop towards electronic data interchange, there will be no float since there will be no delay time.
How to reduce collection float?
The finance manager should take steps to recover debts as quickly as possible, and a proper internal control system should be built in the organization to do this. Once the credit sales are completed, there should be a built-in method for timely debtor recovery. To show the outstanding bills, periodic statements should be generated. Customers should be thoroughly informed about any incentives offered for making early or quick payments. When cheques or notes are received from customers, they should be deposited with the banks as soon as possible. By reducing the time spent by postal intermediaries and banks, the time lag in collecting receivables can be significantly decreased.
In addition, a lockbox system is an efficient way to reduce collection float and streamline collections.
A lockbox service at a bank gives you access to one or more lockboxes, which are essentially post-office boxes that the bank can set up in different places around the country so that your company can accept cheques or payments from clients.
Businesses can collect money more effectively by using lockbox systems. Instead of processing incoming payments yourself (and waiting for those payments to travel through the mail), payments go to a lockbox, where the local bank can collect them, record the details of the transaction for your record-keeping needs, and even deposit the funds into your company’s bank account. Therefore, all the processing and payment handling stuff is managed by the lockbox or the local bank.
Another way to speed up collections is through concentration banking. Here again, decentralized collection centers and regional branches are used to collect payments from customers. Customers are not needed to send the payment to the centralized location.
When a firm has its operations in diverse parts of the country and it wants to ease the complexity of handling multiple bank accounts at different locations, it may opt for a concentration banking system. All the amounts from different regional branches get forwarded to a single bank account called the concentration account.
Conclusion
It is important that float should be managed well so that it does not translate into a huge cost. Not only this, but if it is managed correctly, it can become a source of earnings for your business.
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