Collection float

What Is Collection Float?

Collection float, a core concept in Cash management, refers to the time delay between when a payment is made by a customer and when the funds become available for the recipient company's use. This period represents money that has been sent but has not yet cleared and settled into the company's bank account, effectively making it temporarily unavailable. Understanding collection float is crucial for businesses as it directly impacts their liquidity and overall working capital efficiency. Minimizing collection float is a key objective for optimizing cash flow.

History and Origin

The concept of collection float emerged prominently with the widespread use of paper-based payment systems, particularly checks, which inherently involve delays in physical handling and processing. In the early 20th century, the Federal Reserve System was established in part to address inefficiencies in the national check clearing system, which previously suffered from delays and high interbank costs⁷. Over decades, payment systems evolved from physical currency and early wire transfers to more formalized electronic methods.

Significant legislative efforts, such as the Check Clearing for the 21st Century Act (Check 21 Act) of 2003, were designed to accelerate check processing by enabling banks to handle more checks electronically, reducing the physical transportation time that contributed to collection float⁶. More recently, the development of instant payment systems, such as the Federal Reserve's FedNow Service, launched in 2023, aims to virtually eliminate collection float for participating financial institutions and their customers by enabling payments to be sent and received within seconds, around the clock⁵,⁴. These advancements continue to reshape the landscape of cash management, steadily reducing the impact of collection float.

Key Takeaways

• Collection float is the delay between when a payment is sent and when it becomes available in the recipient's bank account.
• It primarily arises from the time taken for mail delivery, bank processing, and interbank clearing.
• Minimizing collection float improves a company's cash flow and maximizes the availability of funds for operations or investment.
• Technological advancements in payment processing, such as electronic funds transfers and real-time payment systems, aim to significantly reduce collection float.
• Effective treasury management strategies focus on speeding up the collection process.

Formula and Calculation

While collection float isn't typically represented by a single, universal formula like many financial ratios, it can be quantified to understand its impact on a business. The most common way to measure collection float is by calculating the average daily collection float, which is the total value of uncollected funds divided by the number of days in the measurement period. Alternatively, it can be expressed as the average number of days funds are outstanding, weighted by the dollar value of payments.

A simplified way to conceptualize the value of collection float at any given time is:

$\text{Collection Float Value} = \sum_{i=1}^{n} (\text{Amount of Payment}_i \times \text{Days Outstanding}_i)$

Where:

• (\text{Amount of Payment}_i) represents the value of an individual payment currently in the collection process.
• (\text{Days Outstanding}_i) is the number of days that payment has been in transit or processing since it was initiated.
• (n) is the total number of payments currently in the collection pipeline.

Minimizing these "Days Outstanding" is a direct way to reduce the overall collection float. For a business, this calculation provides insight into the capital tied up in the collection process, which could otherwise be earning interest income or used for operational needs.

Interpreting Collection Float

Interpreting collection float involves understanding its financial implications for a business. A higher collection float means that more of a company's cash is tied up and unavailable for use. This can necessitate higher borrowing or reliance on other external funding to meet short-term obligations, potentially increasing financing costs. Conversely, a lower collection float indicates that funds are becoming available more quickly, enhancing a company's financial flexibility and reducing its reliance on costly external financing.

Effective treasury management aims to minimize collection float to improve a company's cash conversion cycle. Businesses often analyze collection float in conjunction with their accounts receivable to identify bottlenecks in the invoicing, payment, and clearing processes. Reducing this float allows a company to deploy its cash more efficiently, whether for reinvestment, debt reduction, or other strategic initiatives.

Hypothetical Example

Consider "Alpha Manufacturing," a company that sells goods to retailers. Alpha invoices its customers for $1,000,000 each week, expecting payment by check within 30 days.

• Day 1: Alpha issues an invoice.
• Day 30: A customer mails a check for $10,000.
• Day 33: Alpha receives the check in the mailroom. The check is then prepared for deposit.
• Day 34: The check is physically deposited at Alpha's bank.
• Day 35: Alpha's bank sends the check to the customer's bank for check clearing.
• Day 37: The funds are officially cleared and become available in Alpha's account.

In this scenario, for that specific $10,000 payment, the collection float period from receipt of payment (mailing of check) to available funds is approximately 7 days (Day 30 to Day 37). If Alpha had 10 such payments totaling $100,000 experiencing this 7-day float, then $700,000 ($100,000 x 7 days) in potential daily available funds is tied up.

If Alpha could persuade customers to pay via Automated Clearing House (ACH) transfers, the collection float could be reduced to 1-2 days, significantly improving the availability of these funds and their overall cash flow.

Practical Applications

Collection float is a critical consideration in various aspects of financial management, particularly within corporate finance.

• Corporate Treasury Operations: Treasury departments actively manage collection float to optimize the firm's cash position. They implement strategies like lockbox systems, which direct customer payments to regional bank post office boxes, reducing mail and processing time. They also encourage customers to use faster payment methods like Electronic funds transfer (EFT), wire transfer, and ACH.
• Working Capital Management: By reducing collection float, companies improve their working capital cycle, needing less short-term financing to cover operational gaps. This is directly reflected in the efficiency metrics derived from financial statements.
• Payment System Design: Banks and payment processors constantly innovate to minimize float. The Real-Time Payments (RTP) network by The Clearing House, for example, offers immediate clearing and settlement, dramatically reducing float for interbank transactions [https://www.theclearinghouse.org/payment-systems/rtp]. Similarly, the FedNow Service represents a public sector effort to achieve instant payments nationwide³.
• Credit and Collections: Companies with high volumes of accounts receivable often employ dedicated credit and collections teams. Their efforts not only focus on timely invoice payment but also on educating customers about and facilitating faster payment methods to minimize collection float.

Limitations and Criticisms

While reducing collection float is generally beneficial, there are certain limitations and criticisms to consider.

• Cost of Faster Methods: Implementing and maintaining systems for faster payment methods (e.g., electronic data interchange, integrated payment platforms) can incur setup and transaction costs. For smaller businesses, the cost savings from reduced float might not always outweigh these expenses.
• Diminishing Returns: As payment technology advances, the remaining float period becomes shorter. There's a point of diminishing returns where further investments to shave off a few hours or minutes of float yield negligible financial benefit. For instance, with the advent of instant payment systems, the traditional sources of collection float from paper checks are becoming less relevant for companies that embrace digital transactions.
• Fraud Risk: While electronic payments can reduce float, they also introduce different types of fraud risk, such as cyberattacks and business email compromise, which require robust security measures. Conversely, traditional paper checks continue to be a significant target for criminals, with check fraud remaining a pervasive issue, as highlighted by organizations like the American Bankers Association². The shift to electronic payments can mitigate some forms of fraud but necessitates vigilance against others.
• Operational Complexity: Managing a mix of payment methods—some fast, some slow—adds complexity to internal accounting and reconciliation processes, impacting the balance sheet.

Collection Float vs. Disbursement Float

Collection float and disbursement float are two distinct but related concepts in cash management, both pertaining to the timing differences in funds movement.

Collection Float is the delay from when a customer pays until the funds are available to the recipient company. It represents money owed to the company that is in transit or processing. Companies aim to minimize collection float to get cash sooner.

Disbursement Float, on the other hand, is the delay between when a company issues a payment (e.g., writes a check) and when the funds are actually debited from its bank account. It represents money owed by the company that has not yet left its control. Companies historically aimed to maximize disbursement float to retain funds in their accounts longer, earning interest or using them for other purposes.

The key difference lies in the direction of the payment and the desired outcome: companies want to speed up collections (reduce collection float) and, traditionally, slow down disbursements (increase disbursement float). However, with the rise of instant payment systems, the ability to generate significant disbursement float is rapidly diminishing, pushing companies to focus primarily on optimizing collection times.

FAQs

What causes collection float?
Collection float is primarily caused by the time required for mail delivery of payments, administrative handling within the recipient's organization, and the interbank clearing and settlement process for transactions like checks or older electronic transfers.

Why is reducing collection float important for businesses?
Reducing collection float is important because it makes cash available sooner, improving a company's cash flow and liquidity. This allows the business to meet obligations, invest, or reduce borrowing more quickly, potentially saving on interest expenses or earning more interest on available balances.

How do businesses reduce collection float?
Businesses reduce collection float by encouraging electronic payment methods like ACH, wire transfers, or credit cards; using lockbox services for physical checks; implementing remote deposit capture; and optimizing internal accounts receivable and deposit procedures.

Does instant payment eliminate collection float?
Yes, instant payment systems, such as the FedNow Service or The Clearing House's RTP network, are designed to eliminate collection float by enabling funds to clear and settle within seconds, 24 hours a day, 7 days a week, 365 days a year. Th¹is means funds are immediately available to the recipient upon payment initiation.

Is collection float always negative for a company?
Generally, yes. Collection float represents money that a company is owed but cannot yet use. While it doesn't represent a loss of funds, it does represent an opportunity cost—the potential for those funds to be earning interest or funding operations. Minimizing it is a common cash management goal.