**Accounts receivable may be financed under either a factoring or receivable financing** [or “**assignment (pledging) arrangement**“]. **Should I use factoring or receivable financing to finance my company? Which is the better option? There is no straight forward answer for the questions. Factoring avoids the need for long-term financing and generates recurring cash flow. However, there are high administrative costs when many small accounts exist**. **In accounts receivable financing, the accounts receivable are the collateral for the loan as well as the source of repayment.**

I discuss both financing alternatives [factoring vs receivable financing] in some analysis through this post.Enjoy!

### Factoring Vs Receivable Financing

**Factoring is the sale of accounts receivable to a finance company without recourse. The purchaser assumes all credit and collection risks**. The amount received equals the face value of the receivables less the commission charge, which is usually 2 to 4 percent higher than the prime interest rate. The cost of factoring is the factor’s commission for credit investigation, interest on the unpaid balance of advanced funds, and a discount from the face value of the receivables where high credit risk exists. Customer payments are made directly to the factor.

## Advantage and Disadvantage Of Factoring

The advantages of factoringare immediate availability of money, reduction in overhead since the credit examination activity is no longer needed, obtaining financial advice, receipt of seasonal advances, and strengthening of the balance sheet position.The disadvantages of factoringare the high cost and the customer’s negative impression because of the change in ownership of the receivables. Furthermore, factors may antagonize customers by their demanding collection methods of delinquent accounts.

**In a receviable financing [assignment (pledging)], there is no transfer of the ownership of the accounts receivable. Receivables are given to a finance company with recourse**. The finance company typically advances between 50 and 85 percent of the face value of the receivables in cash. The company incurs a service charge, interest on the advance, and bad debt losses. Customer remissions continue to be made directly to the company.

**The assignment of accounts receivable [receivable financing] has the advantages of immediate availability of cash, cash advances available on a seasonal basis, and avoidance of negative customer reaction**. The disadvantages include the high cost, the continuance of clerical work on the accounts receivable, and the bearing of all credit risk.

A controller [or CFO] has to recognize the impact of a change in accounts receivable policy on the cost of financing receivables. **The cost of financing may rise or fall under different conditions. For example**:

- when credit standards are eased, costs rise;
- when recourse for defaults is given to the finance company, costs decrease; and
- when the minimum invoice amount of a credit sale is increased, costs decline.

Before analyzing the choices [whether to use factoring or receivable financing], let’s see what the cost of factoring arrangement on the following section. Read on…

### Calculating Cost Of Factoring Arrangement

A factor will purchase the company’s $120,000 per month accounts receivable. The factor will advance up to 80 percent of the receivables for an annual charge of 14 percent, and a 1.5 percent fee on receivables purchased. **The cost of this factoring arrangement is**:

Factor fee [0.015 × ($120,000 × 12)] = $21,600

Cost of borrowing [0.14 × ($120,000 × 0.8)] = 13,440

Total cost = $35,040

### Factoring Vs Receivable Financing Analysis-1

**A factor charges a 3 percent fee per month. The factor lends the company up to 75 percent of receivables purchased for an additional 1 percent per month. Credit sales are $400,000 per month. As a result of the factoring arrangement, the company saves $6,500 per month in credit costs and a bad debt expense of 2 percent of credit sales**.

XYZ Bank has offered an arrangement to lend the company up to 75 percent of the receivables.

The bank will charge 2 percent per month interest plus a 4 percent processing charge on receivable lending. The collection period is 30 days.

If the company borrows the maximum per month, should it stay with the factor or switch to XYZ Bank?

**Cost of factor**:

Purchased receivables (0.03 × $400,000) = $12,000

Lending fee (0.01 × $300,000) = 3,000

Total cost = $15,000

**Cost of bank financing**:

Interest (0.02 × $300,000) = $ 6,000

Processing charge (0.04 × $300,000) = 12,000

**Additional cost of not using the factor**:

Credit costs = 6,500

Bad debts (0.02 × $400,000) = 8,000

Total cost = $32,500

Conclusion: The company should stay with the factor.

### Factoring Vs Financing Receivable Analysis-2

A company needs $250,000 and is considering the alternatives of arranging a bank loan or going to a factor. The bank loan terms are 18 percent interest, discounted, with a compensating balance of 20 per- cent. The factor will charge a 4 percent commission on invoices purchased monthly, and the interest rate on the purchased invoices is 12 percent, deducted in advance. By using a factor, the company will save $1,000 monthly credit department costs, and uncollectible accounts estimated at 3 percent of the factored accounts receivable will not occur.

Which is the better option?

**The bank loan that will net the company its desired $250,000 in proceeds is**:

= Proceeds/(100% – Proceeds deducted)

= $250,000/[100% – (18% + 20%)]

= $250,000/(1.0 – 0.38)

= $250,000/0.62

= $403,226

**The effective interest rate of the bank loan is**:

Effective interest rate

= Interest rate /Proceeds(%)

= 0.18/0.62

= 29.0%

**The amount of accounts receivable that should be factored to net the ?rm $250,000 is**:

= $250,000/(1.0 – 0.16)

= $250,000/0.84

= $297, 619

**The total annual cost of the bank arrangement is**:

Interest ($250,000 × 0.29) = $72,500

**Additional cost of not using a factor**:

Credit costs ($1,000 × 12) = 12,000

Uncollectible accounts ($297,619 × 0.03) = 8,929

Total cost = $93,429

**The effective interest rate associated with factoring accounts receivable is**:

Effective interest rate = Interest rate/Proceeds(%)

= 12%/[(100% – (12% + 4%)]

= 0.12/0.84

= 14.3%

**The total annual cost of the factoring alternative is**:

Interest ($250,000 × 0.143) = $35,750

Factoring ($297,619 × 0.04) = 11,905

Total cost = $47,655

Conclusion:The factoring arrangement should be selected because it costs almost half as much as the bank loan.

### Receivable Financing Vs. Factoring Analysis-3

A company is examining a factoring arrangement. The company’s sales are $2.7 million, accounts receivable turnover is nine times, and a 17 percent reserve on accounts receivable is required. The factor’s commission charge on average accounts receivable payable at the point of receivable purchase is 2.0 percent. The factor’s interest charge is 16 percent of receivables after subtracting the commission charge and reserve. The interest charge reduces the advance. The annual effective cost under the factoring arrangement is computed next.

**Average accounts/receivable:**

= Credit sales/Turnover

= $2,700,000/9

= $300,000

**The company will receive the following amount by factoring its accounts receivable**:

**Average accounts receivable** = $300,000

Less: Reserve ($300,000 × 0.17) = (51,000)

Commission ($300,000 × 0.02) = ( 6,000)

**Net prior to interest** = $243,000

Less: Interest ($243,000 × (16%/9) = (4,320)

Proceeds received = $238,680

**The annual cost of the factoring arrangement is**:

Commission ($300,000 × 0.02) = $ 6,000

Interest ($243,000 × (16%/9) = 4,320

Cost each 40 days (360/9) = $ 10,320

Turnover × 9

Total annual cost = $ 92,880

**The annual effective cost under the factoring arrangement based on the amount received is**:

**Annual cost/Average amount received**

= $92,880/$238,680

= 38.9%

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