Introduction to Corporate Finance

ONLINE CHAPTERS

Some of the primary advantages of using a system such as the EIPP for business-to-business payments

are: (1) reduced float to the receiving party; (2) lower costs, both of receivables processing for the receiver

and of payment initiation and reconciliation costs for the payer; and (3) better forecasting for both parties.

Though there may be a need to negotiate payment dates and possible discounts for earlier payment,

companies that have implemented electronic payments report significant overall savings as a result.

The future for electronic collections systems appears to look good, as more and more companies are

implementing some form of electronic invoicing and payment. Many of these systems are implemented

by large companies as a means to streamline the billing of their (often smaller) customers and automate

the payment process. Companies that must pay a large number of smaller suppliers are also implementing

electronic systems as a means to reduce their overall costs of running accounts payable and disbursement

systems.

19-2b LOCKBOX SYSTEMS

A lockbox system is a popular technique for speeding up collections, because it affects three components

of float. It works like this: instead of mailing payments to the company, customers mail payments to a

post-office box, which is emptied regularly by the company’s bank. The bank processes each payment

and deposits the payments into the company’s account. The bank sends (or transmits electronically)

deposit slips and enclosures to the company so the company can properly credit its customers’ accounts.

Lockboxes are typically dispersed geographically to match the locations of the company’s customers.

The main banks in Australia offer lockbox services for their customers throughout the country. As a

result of being near a company’s customers, lockboxes reduce mail time and clearing time. They reduce

processing time to nearly zero, because the bank deposits payments before the company processes them.

Obviously, a lockbox system reduces collection float, but not without a cost. Therefore, a company

must perform a cost–benefit analysis to determine whether a lockbox system should be implemented.

Equation 19.1 presents a simple formula for the cost-benefit analysis of a lockbox system:

Eq. 19.1 Net benefit or cost of lockbox = (FVR × ra) – LC

where

FVR = Float value reduction in dollars

ra = Cost a of capital

LC = Lockbox cost (annual operating cost of the system)

Thus, if the return on the float reduction exceeds the cost of the lockbox system, the company should

implement the lockbox system.

example

Consider Reese Industries, from Chapter 18, which has

$5 billion in annual sales and eight days of customer

collection float in its cash conversion cycle. Reese

wants to determine if it should implement a lockbox

system that reduces customer collection float to five

days. The reduction in float value from decreasing

customer float from eight days to five days is $41.1

million [$5 billion × (3 days ÷ 365 days)]. Reese has

a cost of capital of 13.5% per year. Thus, the value

to Reese of reducing customer float by three days

is $5.55 million (0.135 × $41.1 million). If the annual

cost of the lockbox system is less than $5.55 million, it

would be beneficial to implement the system.

LO19.2

lockbox system
A technique for speeding up
collections that affects all
three components of float.
Customers mail payments
to a post office box, which
is emptied regularly by the
company’s bank, which
processes and deposits the
payments