Question

Fisher-Gardner Corporation (FGC) began operations 5 years ago as a small firm serving customers in the Chicago area. However, its reputation and market area grew quickly. Today FGC has customers all over the United States. Despite its broad customer base, FGC has maintained its headquarters in Detroit, and it keeps its central billing system there. On average, it takes 7 days from the time customers mail in payments until FGC can receive, process, and deposit them. FGC would like to set up a lockbox collection system, which it estimates would reduce the time lag from customer mailing to deposit by 2 days-bringing it down to 5 days. FGC receives an average of $2,300,000 in payments per day.

How much free cash would FGC generate if it implemented the lockbox system? Would this be a one-time cash flow or a recurring one, assuming the company creates to grow. How would growth affect your answer?

Answer 1

The benefit FGC would realize from shortening the payment cycle from 7 days to 5 days is from additional interest received by depositing the cash earlier in the bank account. It also has a potential for better cash flow and liquidity management. There would be a one-time jump in the cash receipt when the lockbox is set up for the first time. Suppose the lockbox is set up on 1^st May. The checks which would have otherwise been cashed on 5^th, 6^th and 7^th May, would all be received on 5^th May. Hence, the cash receipts for this day would spike. After this, the cash receipts would reach its previous normal levels. There would be a drop in the accounts receivable. Currently, FGC has $2.3 M *7= $16.1 M accounts receivable. This would change to 2.3 M *7= $11.5 M after the lockbox is set up. This would be the new average accounts receivable level. This will increase the cash received from operations for the firm in the current period.

Consider a scenario where the company is not growing but maintaining a steady sale. The only benefit FGC will realize is from interest receipt. The checks are received at a steady pace and the liquidity is not a major concern for payment received in 5 days vs in 7 days. However, the company stands to receive an additional interest of ($2.3 M* 2* APR on account / 365) from setting up a lockbox. For example, at 2% rate of interest on the account, the company stands to realize $126 extra per day or $46,000 per year. This would be an ongoing benefit.

Now consider a stage where the company is growing at a considerable pace. Looking at the growth of the company so far, it is very likely that the company would continue growing at a fast pace in near future. In this case, being able to cash the checks earlier would provide incremental free cash flows to the company, as the sales continue to grow. The interest received from depositing them in bank account is a small benefit compared to the boost it will have in managing the firm’s liquidity and cash cycle. This would be an ongoing benefit.