Dealing with check 21: keeping your head above

water in a world without float

by

Dan Davidson

Professor of Business Law

Radford University

Radford, VA 24142

ddavidso@radford.edu

(540) 831-5071

and

Steven Beach

Assistant Professor of Finance

Radford University

Radford, VA 24142

slbeach@radford.edu

(540) 831-5087

Dealing with check 21: keeping your head above

water in a world without float

Introduction

            Cash flow management is an essential skill for businesses, especially for small businesses. Advice for managing cash flow is available from numerous sources. However, these resources have yet to address the implementation of the check clearing for the 21st Century (Check 21) legislation.[1]  Many of these sources pay particular attention to small businesses, providing resources that small business owners can utilize to improve their cash flow management. (See, e.g., Bounds or Masonson) Much of the focus of advice on cash management has been on how businesses can increase "float," the time between when a check is issued and the money is removed from the account of the check issuer. (Ross et al., 639-645)  While this information has been valuable and important in the past, the enactment of Check 21 will require a reevaluation of how to manage cash flow. (Blasingame) No longer will float be a major factor. In fact, float may be virtually eliminated in the near future, requiring the development of new tools and new methods for managing cash flow. (Weston) While these changes will impact all businesses, they will be most significant to small businesses and especially for those operating at or near the margin.

Check 21

            In October of 2003 Congress passed Public Law 108-100, the Check Clearing for the 21st Century Act, better known as Check 21. President Bush signed the act into law October 28, 2003, and it became effective October 28, 2004. (Federal Reserve Board)  While the title to the act implies that it addresses various aspects of check clearing, that is not the case. Instead, Check 21 provides the guidelines and rules for check truncation (Federal Reserve Board).  Checks are truncated when the original paper check is removed from circulation, being replaced by a digital image that can be moved through the collection process electronically. Such a transformation of the check from paper to digital image will markedly increase the speed with which it can be processed while simultaneously reducing the expenses associated with the handling of checks that has traditionally been required. Since check truncation will shorten the time a check is in the check collection system, the checks will arrive at the paying bank much quicker, thus reducing the "float" available on a check.  In fact, once Check 21 is fully implemented checks may be presented to the drawee (paying) bank within hours of the time they are deposited rather than the days that may elapse under the traditional method of handling checks.  It is estimated that Check 21 will result in savings of as much as $2 billion for banks in the first year of the statute, with increased savings in the future as more banks implement truncation. (Sullivan)  Most of the savings will be related to quicker clearing of checks, but there are also significant savings by negating the need for physical handling and transporting of checks, especially over long distances. This reduced time that a check will be moving through the system will have significant implications for businesses. As checks move through the system more quickly, money will, of necessity, be removed from the account of the drawer (issuer) of the check more quickly. This, in turn, will require the drawer to take steps to insure that he or she has adequate funds on deposit to cover the check, or that some form of overdraft protection is available to ensure that all the checks issued will be paid despite their earlier arrival at the drawee bank.

Cash Flow

            There are a number of things that small businesses can do in order to enhance their cash inflow. Fast Collection (built on rapid invoicing) and prompt check depositing are obvious first steps, although both rely on receiving checks from customers, something that is beyond the control of the business-as-payee. In addition, the business can request quicker availability of funds from its bank. The bank should be willing to make funds available to the business within zero to two days from the time checks are deposited, in contrast to the one to five day availability generally provided for most customers. Especially now, given the bank's expectation of quicker processing and collection under the provisions of Check 21, the business should be able to arrange for quicker availability of funds from its deposits. In fact, zero to one-day availability should be possible. If the business cannot obtain this level of service from its bank, the business should consider moving its business to a more accommodating bank that will provide such service. Virtually immediate availability of funds, in effect treating a check similarly to the manner in which debit card transactions are treated, is on the horizon once Check 21 is fully implemented.

            Problems in Accounts Receivable management can have a major impact on cash flow. Even in those cases of full collection on all accounts, slow collection can impose a real cost to a small firm. Additional cash balances must be held to offset slow collections. Among the devices traditionally recommended for businesses that are seeking to improve the quality of accounts and to speed their collection is refusing to deliver products to customers with unpaid bills. However, this may lead to the loss of a customer, which has an even greater impact on cash flow in the long term due to lost sales. Instead, the business may consider methods for reducing check handling by having their banks automatically redeposit all returned checks. If the bank offers a return item box service, returned checks will be automatically redeposited and the bank's returned item fee will be automatically charged to the customer whose check was returned. With use of a return item box service a business reduces its administrative time and effort in managing receivables, as well as reducing the number of bad accounts.

            Slow disbursements of funds by a payer have traditionally increased the payer's float. Most techniques for slowing disbursement will remain intact under Check 21. However, the use of out-of-state, and often remote, disbursement checking accounts (a method primarily used by larger corporations) may no longer be a viable option. With check truncation, the check may reach the out-of-state or remote location within a day of its deposit by the payee, virtually eliminating the time lag between deposit and presentment to the drawee bank despite the drawee bank's location.  Waiting until the last day before submitting payment on payables is the most significant cash flow enhancing technique that will remain intact under Check 21. However, the speed of check processing and clearing now available under Check 21 will reduce the float benefits of even this method of slower disbursement.

            The increased speed in disbursements being debited from the small business's checking account is the most significant impact upon cash flows as a result of Check 21. The clearest approach to offsetting the increased speed of the cash outflow is to maintain a larger cash balance. Unfortunately, this increase in the cash balance will result in a cost to the firm. The total net cost to the firm will be the dollar amount of increase in the cash balance less the discounted value of the "recovered" cash flows. The recovered cash flows are realized as the minimum maintained cash balance is allowed to decrease back toward the level used before the adjustment. Since there is no reason to believe that the total recovery of cash flow will be swift, nor will it be total (i.e., 100%), then it is safe to assume that the firm will incur a cost. Estimating an expected total cost at this point is unrealistic because so many variables in the analysis are still uncertain, as will be discussed later in this paper. However, the immediate investment needed can be estimated with reasonable accuracy, as will be shown later.

            A small business should look to increase its line of credit, or arrange some other means of overdraft protection, as an additional step to ensure that it will not be subjected to charges for issuing NSF (non-sufficient funds) checks as float "evaporates" and checks are processed and cleared more rapidly. The initial investment in cash that will be needed by a small firm will be viewed as "costs." In the following sections these costs will be addressed by examining how they would impact different firms, based on how each firm has previously used float. Finally, a simple cash flow example will illustrate the possible impact from the loss of float.

Costs Associated with Check 21

            Consider a small firm that currently does not make use of float and does not expect any changes in its cash flow needs. Such a firm will still face potential cash flow problems that could result from bad checks written to the firm by its customers. Such a firm may want to purchase and install a check scanning terminal, effectively allowing the firm to transfer any payments it receives by check into electronic fund transfers, and treating the payments as debit card transactions. The cost of such a scanning terminal will range from $15 to $25 per terminal per month. It is expected that such terminals would have a primary benefit to a small firm by providing for virtually immediate receipt of revenues and by providing fraud protection, and that these benefits would offset the cost of the terminal. The benefits of using such a check-processing terminal will also offset the expenses of handling checks and loss of float, together with a reduction in processing fraudulent or insufficient funds checks in the traditional manner.  The increased speed of its own checks being processed as Check 21 is implemented would increase the potential for administrative hassles from any NSF checks and fraudulent checks. Thus, system-wide efficiency creates a risk for the individual firm, a risk that is best reduced by using a remote check-processing terminal.

            Such a system would entail additional expenses of $15 to $25 per month per terminal, but the cost savings would result from greater efficiency due to reduced manual processing and a reduced need for account collection operations.

Different Impacts on Different Firms

            It is easier to illustrate the impact of Check 21 on a small business than to explain it. The following examples are highly stylized because a firm cannot expect cash flows to be as consistent as they appear in these illustrations.

            First take a small firm that currently makes use of, and relies on, float, but a firm that has not written any checks that have subsequently been returned due to nonsufficient funds. This firm should have a relatively easy time making the transition to the "brave new world" of Check 21. It will need to obtain an increase in its credit line, with the credit line tied to its checking account, and which should have no cost; and it will need to increase its checking account balance to cover its expected financial needs, which will have a cost.

            The increase in the cash balance is generally considered a one-time expense that may or may not be recovered subsequently. The speed with which major financial institutions and regional banks adopt Check 21 will ultimately determine the speed with which the small firm must respond in some fashion. In addition to the lack of specificity regarding the timing of this "required" implementation, which will then lead to some recovery of the initial investment, it is difficult to determine the exact percentage of the initial investment (the increase in the cash balance) that will be recovered (in a subsequent reduction in the required cash balance) as the new processing system becomes the normal method.  The required dollar amount, combined with an increase in the credit line for the firm, should be approximately the same as the usual float previously used. An example that provides guidelines for identifying the required amount is set out below.

            Second, take a small firm that currently makes use of float, but one that has written checks that have been returned due to nonsufficient funds. Since this firm has experienced problems due to its issuance of NSF checks, it may be unable to acquire a line of credit, or it may not be able to obtain an increase in its line of credit that is adequate for its purposes. Thus, the firm will need to increase its cash balance to cover its expected financial needs. The cost for such an increase in the cash balance will be similar to the costs for the firm that has been able to successfully utilize float except that the cash balance increase will need to be greater since no additional protection is provided by the use, or increase, in the credit line of the firm.

Cash Flow Examples: Before and After Check 21

            Now let’s examine a cash flow example of a profitable firm with $410,400 in annual net revenue. Initially this business utilizes some float and is able to meet all of its expenses as they come due. Then float is reduced, as will happen with Check 21. How will the reduction in float affect the cash flow of the business? In the first scenario this business utilizes some float and is able to meet all of its expenses as they come due. Then, this business is analyzed after a reduction in float, much like the expected impact of Check 21. The year of 2006 is examined, with the analysis starting from Monday, January 2, 2006. The revenues of the firm are $9,000 per week from January 2 to January 29, and then from May 22 until the end of the year. In the slower January 30 through May 21 timeframe, the revenues fall to $5,400 per week.

            This hypothetical small firm carries a starting cash balance of $13,925, labor expense of 30% of sales, materials expense of 26% of sales, and rent and general administrative expense of $15,000 per month (43.86% of net revenue). For our example, the general and administrative expense includes the owner's draw as well as escrow for any taxes not immediately pulled from sales revenue.  After the total expenses of 99.86%, not much is left for return on initial investment, but this small firm is profitable, with a profit margin of .14%.

Before Check 21

            Consider a situation with 62.5% in cash equivalent revenue and 37.5% in check revenue with a 2-day collection delay, labor paid biweekly with a one-week lag, and the Monday to Saturday operating week’s material costs paid on Friday. In a case with the paychecks being honored with a 2-4 day float (at 50%, 25%, and 25% clearing on the 3 days) this small firm maintains positive cash flow for the entire year, with its lowest cash balance of $23 occurring on May 1, immediately after payment of the rent and general administrative expense made at the start of the month. This small profit margin allows the firm to start the following year with a larger cash balance, at $14, 501.

After Check 21

            To simulate a situation in which float is not available to the small firm, two adjustments are made in the cash flows. First, it is assumed that the labor expenses will clear immediately upon payment. Secondly, the month’s payment of rent and administrative expenses will clear two days earlier, no longer on the first day of the month, but on an actual due date of two days before the month begins.

            With the elimination of float, this small firm suffers its first cash shortage of $1777 on April 28. The largest cash shortage of $1999 occurs on June 4, two weeks after revenues move back to the $9,000 per week level. In our simplified example, a reduction in the cash balance is only observed for about 6 days per month. The elimination of the 2-4 day float, however, still creates a cash flow bottleneck for this small firm. In the chart below, covering January 1 through July 31, the cash balances under the "with Float" and "no Float" scenarios are provided. The lower balances in the no Float case clearly occur when payments are being made on the various expenses.

            In Exhibit 1, the focus is on the period leading to the largest cash flow shortage (in the no Float scenario) of $1999 on June 4. On May 29, the difference relative to the case with Float (-$1,884 versus $13,116) results from the two-day earlier clearing of the rent check. By June 4, however, the cause is no longer the rent payment, but the clearing of payroll checks, resulting in the greatest cash shortage of the example.

            Assuming that no other adjustments to the timing of the cash payments are possible, this firm will have to find some way to finance this $1999 cash shortfall. One alternative to consider is a change in the contractual timing of payments related to the most sizable costs that have required the use of float (like rent and the wage payments in our example). Here, a permanent change of two days later payment of rent and wages will significantly improve the cash position of the business. Unfortunately, it is not likely that all parties involved are willing to accept such a change.

            If the timing of payments cannot be changed, as is likely, this firm has to increase its cash balance by at least $1,999 (and it should be more to avoid a zero balance in the account). With this increase of $1999 to the cash balance, the cost of this financing depends on the opportunity cost of capital and the timing of the recovery of this "investment," as described earlier in the paper. If the small firm has to reduce the level of funds in a savings or other interest bearing account, the cost is the interest rate on the investment account. Other possible sources include the small business owner providing the cash infusion, which then places the cost at the cost of equity (i.e. the return the entrepreneur desires from the investment into the firm). This approach is consistent with overall opportunity costs to the owner, which may be based on the expected return on real property or stock investment that may be sold to free up the cash.

Estimating Additional Cash Needs

            How do you estimate the necessary increase in cash balance? The best way to calculate your small firm’s additional cash financing is through an analysis of past daily cash balances. This information is available from the bank in the form of an account analysis, essentially the bank’s invoice of your account. A year’s worth of daily account balances provided by your financial institution should be compared to your in-house checking account ledger. The bank should be willing to provide this statement free of charge as a service to the customer small firm. The small business can argue that this one-time request is necessitated by the implementation of Check 21, thus the bank should be expected to provide the information without charge.

            At the end of business on Saturday, June 3, the simulated firm had a cash balance of $2,026 and expected cash receipts of $1375 on Sunday, expenses of $5400 for labor, resulting in the -$1999 balance in the no Float scenario ($2026 + $1375 – $5400). One intuitive approach to estimating the necessary cushion is to focus on the amount of "float" funds used relative to the cash balance. The net level of payments in float was $5400 - $2026 = $3374. This amount is a safer cushion, because of the uncertainty regarding the level of cash flow expected in the interim. The firm’s checkbook records should identify the negative balances that represent the float utilized. In our example, the $2026 less the $5400 payroll checks gives the $3374 shortage. Checkbook accounting would identify this negative balance.

            If the small business were to offset the loss of float by installing a check scanning terminal, the positive cash flow benefits do not appear to be sufficient, in this case, to overcome the cash shortage. Assuming 100% immediate collection on all sales, and the associated increase in initial cash balance from $13,925 to $15,050, the business still experiences a cash shortfall when losing the benefit of float on its disbursements. The largest cash balance deficit now occurs on May 29, with a negative balance of $1,134. The upswing in revenues, beginning on May 23, is sufficient to offset some of the cash shortage by June 3, reducing the shortfall from $1,999 to just $874. It is possible to create a hypothetical example in which the shortened time in converting sales to cash would be sufficient to avoid a cash shortage.

Dealing with Check 21 

Beyond use of a check scanner, what is a small firm to do? There are three other options for a small firm: the firm can increase its line or credit or increase its overdraft protection agreement with its bank; the firm can deposit additional funds, increasing its checking account balance to finance the anticipated cash shortfall; or the firm can seek cooperation from the parties to whom it makes payments, trying to arrange different payment schedules in order to avoid the anticipated cash shortfalls.  But there are costs or concerns associated with these recommendations, whether they are opportunity costs, financial costs, or a combination of the two. Increasing the line of credit or the overdraft protection agreement the firm has with its bank results in an increase in the firm’s available debt, making future long-term credit more difficult to obtain, and likely more expensive if obtained. Depositing additional funds into the firm’s account is an increase in the owner’s investment of cash, which will result in a reduction in the firm’s return on investment and the owner’s return on equity. Rescheduling payments made to suppliers, employees, and creditors, while trying to reschedule payments received from customers is extremely unlikely. It will be difficult for the firm to identify any benefits to the other parties, or to convince them to change their cash management for the benefit of the firm. (See Exhibit 2.)

Conclusions

            Check 21, the Check Clearing for the 21st Century Act, is expected to have a significant impact on the speed with which checks are processed. The primary effect will be that checks will clear faster, thus removing the funds from the account of the issuer of the check much more quickly than before. This, in turn, means that "float," the time between issuing a check and having the funds removed from the issuer's account, will be greatly reduced, or even eliminated. However, Check 21 does not mean that the payee of the check will receive his or her funds any sooner. The availability of funds is still governed by the rules established under the Expedited Funds Availability Act. [2] As a result, it is estimated that an additional seven million checks a month will be dishonored or paid as overdrafts under the new law. (Consumers Union) While the vast majority of these checks are expected to be issued by consumers, quite a few will be issued by businesses, especially smaller businesses. The resulting fees imposed, and the potential effect on the credit record of these firms, could have a devastating impact on the firms.

Businesses will need to maintain a larger account balance in their checking accounts, or will need to make arrangements to protect against overdrafts as checks are presented to the bank for payment. Businesses will need to pay more attention to when payments are scheduled on recurring debts or obligations, and plan more carefully before agreeing to payment dates.  Businesses may also want to consider the benefits to accepting payments electronically rather than by check, thus procuring their funds more quickly than they would by manually depositing checks from their customers.  One possible response was set out at the end of the scenario above: acquire a check scanner. Three additional recommendations were also provided that can help both businesses to avoid these potential problems and to also avoid the associated fees and expenses that would be incurred.

            Check 21 opens up a "brave new world" for handling checks and checking. Businesses that adapt to this new environment will not be unduly harmed, and some may even flourish. Businesses that do not adapt will face increased costs, reduced revenues, and the myriad of problems that accompany such a negative financial position.

Exhibit 2:  Three Approaches to Dealing with Check 21

References

Blasingame, Jim. "The Death of the Float" at http://www.jbsa.com/articles/writethisonarock/float.shtml, Jim Blasingame: The Small Business Advocate, 2004 (last visited September 4, 2005 – authors have copy).

Bounds, Gwendolyn. "How a New Banking Law will Impact Small Firms," The Wall Street Journal Online, (WSJ.com), at http://www.startupjournal.com/columnists/enterprise/20040610-bounds.html  (last visited September 4, 2005 – authors have copy).

Consumers Union, "Consumers Union opposes the Check Truncation Act because:" at http://www.consumersunion.org/finance/checkwc102 (last visited September 4, 2005 – authors have copy).

Federal Reserve Board, "Check Clearing for the 21st Century Act," http://www.federalreserve.gov/paymentsystems/truncation/

Masonson, Les, Cash, Cash, Cash: The Three Principles of Business Survival and Success, Harper Business (HarperCollins Publishing, 1990).

Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordan, Fundamentals of Corporate Finance, 7th ed., McGraw-Hill/Irwin (Boston, MA, 2006).

Sullivan, Bob, "A new era in banking begins," MSNBC.com, http://www.msnbc.msn.com/id/5880440/ (last visited September 4, 2005 – authors have copy).

Weston, Liz Pulliam, "Your checkbook just became obsolete," MSN Money at http://www.moneycentral.mes.com/content/Banking/Betterbanking/P90617.asp