Accounts Receivable Factoring
In general, 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 “assignment” or “factoring.”
Receivable Financing with Assignment Arrangement
In short, there is no transfer of the ownership of the accounts receivable in an assignment arrangement. 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.
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.
The advantages of factoring include:
- Immediate availability of cash
- Receipt of advances as needed on a seasonal basis
- Strengthening of the balance sheet position
- Reduction in overhead since the credit examination function is no longer required
- Utilization of financial advice
The drawbacks to factoring include:
- High cost
- The poor impression left with customers because of the change in ownership of the receivables.
- Factors may antagonize customers by their demanding methods of collecting delinquent accounts.
The financial manager should be aware of the impact of a change in accounts receivable policy on the cost of financing receivables. For example: when accounts receivable are financed, the cost of financing may rise or fall under different conditions. For instance:
- when credit standards are relaxed, costs increase;
- when recourse for defaults is given to the finance company, costs decrease;
- 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.
Determining Cost of Factoring
A factor will purchase ABC 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
Determining Annual Effective Cost of Factoring
Let’s do an example. Say, Lie Dharma Putra 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?
Step-1. Determine the average accounts receivable:
Average accounts receivable = credit sales / turnover
= $2,700,000 / 9 = $300,000
Step-2. Determine the Proceed that will be received:
Lie Dharma Putra 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 [$243,000 x (16%/ 9)] (4,320)
Proceeds received $238,680
Step-3. Determine the annual cost of the factoring arrangement. Here it 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
Step-4. Calculate the annual effective cost:
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%
That is barely easy, is it? Next, let’s do a case example that involving some judgment—a little bit more analytical, rather than plainly numbering and calculator utilization 🙂
Let’s say, The “Works Wealth Wisely Company” has been negotiating with the ABC Bank with the hope of finding a cheaper source of funds than their current factoring arrangements. Forecasts indicate that, on average, they will need to borrow $180,000 per month this year–which is approximately 30 percent more than they have been borrowing on their receivables during the past year. Sales are expected to average $900,000 per month, of which 70 percent are on credit.
As an alternative to the present arrangements, ABC Bank has offered to lend the company up to 75 percent of the face value of the receivables shown on the schedule of accounts. The bank would charge 15 percent per annum interest plus a 2 percent processing charge per dollar of receivables assigned to support the loans. Works Wealth Wisely Company extends terms of net 30 days, and all customers who pay their bills do so by the 30th of the month. The company’s present factoring arrangement costs them a 2.5 percent factor fee plus an additional 1.5 percent per month on advances up to 90 percent of the volume of credit sales.
Works Wealth Wisely Company saves $2,500 per month that would be required to support a credit department and a 134 percent bad debt expense on credit sales.
(a) What is the expected monthly cost of the bank financing proposal?
(b) What is the expected monthly cost of factoring?
(c) Find out at least three advantages of factoring.
(d) Find out at least three disadvantages of factoring
(e) Would you recommend that the firm discontinue or reduce its factoring arrangement in favor of ABC Bank’s financing plan? Explanation is required!
Let’s do it one-by-one:
(a) The expected monthly cost of bank financing-is the sum of the interest cost, processing cost, bad debt expense, and credit department cost. The calculations are as follows:
Interest [(0.15/12) x $180,000] = $ 2,250
Processing [0.02x($180,000/0.75)] = 4,800
Additional cost of not using factor:
credit department = 2,500
Bad debt expense
(0.0175×0.7x$900,000) = 11,025
Expected monthly cost of bank financing = $20,575
(b) The expected monthly cost of factoring – is the sum of the interest cost and the factor cost. The calculations are as follows:
Interest (0.015 x $180,000) = $ 2,700
Factor (0.025 x 0.7 x $900,000) = $15,750
Expected monthly cost of factoring = $18,450
(c) The following are possible advantages of factoring:
- Using a factor eliminates the need to carry a credit department.
- Factoring is a flexible source of financing because as sales increase, the amount of readily available financing increases.
- Factors specialize in evaluating and diversifying credit risks.
(d ) The following are possible disadvantages of factoring:
- The administrative costs may be excessive when invoices are numerous and relatively small in dollar amount.
- Factoring removes one of the most liquid of the firm’s assets and weakens the position of creditors. It may mar the firm’s credit rating and increase the cost of other borrowing arrangements.
- Customers could react unfavorably to a firm’s factoring their accounts receivable.
(e) Based upon the calculations in parts (a) and (b), the factoring arrangement should be continued. Reasons: The disadvantages of factoring are relatively unimportant in this case, especially since Works Wealth Wisely Company has been using the factor in the past. Before arriving at a final decision, the other services offered by the factor and bank would have to be evaluated, as well as the margin of error inherent in the estimation of the source data used in the calculations for parts (a) and (b). The additional borrowing capacity needed by Works Wealth Wisely Company is irrelevant because the firm needs only $180,000, the bank will loan (=$900,000 x 0.70 x 0.75) = $472,500, and the factor will lend (=$900,000 x 0.70 x 0.90) = $567,000.
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