### Accounts Receivable

# Accounts Receivable Financing: Factoring Vs Bank Financing

**Accounts receivable financing has several advantages, including avoiding the need for long-term financing and obtaining a recurring cash flow base. Accounts receivable financing has the drawback of high administrative costs when there are many small accounts. However, with the use of computers these costs can be curtailed. Accounts receivable may be financed under either a **“**factoring**“** or **“**assignment arrangement**“**. Factoring refers to the outright sale of accounts receivable to a bank or finance company without recourse**.

**The purchaser takes all credit and collection risks**. The proceeds received by the selling company are equal to the face value of the receivables less the commission charge, which is typically 2 to 4 percent higher than the prime interest rate. The cost of the factoring arrangement 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 risks exist. Remissions by customers are made directly to the factor.

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**The advantages of factoring include**:

- Immediate availability of cash
- Reduction in overhead since the credit examination function is no longer required
- Utilization of financial advice
- Receipt of advances as needed on a seasonal basis
- Strengthening of the balance sheet position

**The drawbacks to factoring include both the high cost and the poor impression left with customers because of the change in ownership of the receivables**. Also, factors may antagonize customers by their demanding methods of collecting delinquent accounts. In an assignment, 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 borrower is responsible for a service charge, interest on the advance, and any resulting bad debt losses. Customer remissions continue to be made directly to the company.

**The assignment of accounts receivable has a number of advantages, including the immediate availability of cash, cash advances available on a seasonal basis, and avoidance of negative customer feelings**. The disadvantages include the high cost, the continuance of the clerical function associated with accounts receivable, and the bearing of all credit risks.

**The financial manager should be aware of the impact of a change in accounts receivable policy on the cost of financing receivables**.

**Example**

**When accounts receivable are financed, the cost of financing may rise or fall under different conditions**. For instance: (1) when credit standards are relaxed, costs increase; (2) when recourse for defaults is given to the finance company, costs decrease; and (3) when the minimum invoice amount of a credit sale is increased, costs decrease.

The finance manager should compute the cost of accounts receivable financing and select the least expensive alternative.

**Example**

**A factor will purchase Ryan Corporation’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 x ($120.000 x 12)] = $21,600

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

Total cost = $35,040

**Example**

Lie Dharma Corporation needs $250,000 and is weighing 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 percent required. 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, Lie Dharma 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 alternative for Lie Dharma?**

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

= Proceeds / [100% – (percent deducted)]

= $250,000/ (100% – (18% + 20%)]

= $250,000 / (1 – 0.8)

= $250,000 / 0.62

= $403,226

**The effective interest rate associated with the bank loan is**:

= interest rate / proceeds, %

= 0.18/ 0.62

= 29.0%

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

= $250,000 / (1:0 x 0.16]

= $250,000 / 0.84

= $297,619

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

Interest ($250,000 x 0.29) = $72,500

Additional cost of not using a factor:

Credit costs ($1,000 x 12) = $12,000

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

Total cost =$93,429

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

= 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 x 0.143) = $35,750

Factoring ($297,619 x 0.04) = $11,905

Total cost = $47,655

Factoring should be used since it will cost almost half as much as the bank loan.

**Example**

Putra Corporation’s factor charges a 3 percent fee per month. The factor lends the firm up to 75 percent of receivables purchased for an additional 1 percent per month. The company’s 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 where it will lend the firm 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 Putra Corporation borrows the maximum allowed per month, should the firm stay with the factor or switch to XYZ Bank?**

**Cost of factor**:

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

Lending fee (0.01 x $300,000) = 3,000

Total cost = $15,000

**Cost of bank financing**:

Interest (0.20 x $300,000) = $ 6,000

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

Additional cost of not using the factor:

Credit costs = $ 6,500

Bad debts (0.02 x $400,000) = $ 8,000

Total cost = $32,500

Putra Corporation should stay with the factor.

**Example**

Dharma Company is considering a factoring arrangement. The company’s sales are $2,700,000, accounts receivable turnover is 9 times, and a 17 percent reserve on accounts receivable is required by the factor.

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 on receivable after subtracting the commission charge and reserve. The interest charge reduces the advance.

**What is the annual effective cost under the factoring arrangement?**

**Average accounts receivable:**

= credit sales / turnover

= $2,700,000 / 9

= $300,000

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

Average accounts receivable = $300,000

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

Commission ($300,000 x 0.02) = -6,000

Net prior to interest = $243,000

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

Proceeds received = $238,680

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

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

Interest [$243,000 x (16%/9)] = $ 4,320

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

Turnover x 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%