Bank Loans Versus Accounts Receivable Factoring Decisions
On the previous page-1 and page 2, bank loans financing and accounts receivable factoring has been discussed. In this section, those both alternatives will be compared. If you’re not sure, you can always go back to page-1 (bank loans financing) or page-2 (accounts receivable factoring) to recall the concept.
Bank Loans Vs Factoring Case Example-1
XYZ 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, XYZ 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 XYZ?
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 – 0.38) =
$250,000 / 0.62 =
The effective interest rate associated with 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 firm $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 x 0.143) = $35,750
Factoring ($297,619×0.04) = $11,905
Total cost = $47,655
Decision: Factoring should be used since it will cost almost half as much as the bank loan.
Bank Loans Vs Factoring Case Example-2
Lie Dharma 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 Lie Dharma Corporation borrows the maximum allowed per month, should the firm stay with the factor or switch to XYZ Bank?
Cost of factor:
Purchased receivables (0.03x$400,000) = $12,000
Lending fee (0.01x$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 (0.02x$400,000) = $ 8,000
Total cost = $32,500
Decision: Lie Dharma Corporation should stay with the factor.
Bank Loans Vs Factoring Case Example-3
Lie Dharma Corporation needs $400,000 additional financing. The company is considering the choice of financing with a bank or a factor. The bank loan carries a 20 percent interest rate on a discount basis with a required compensating balance of 16 percent. The factor charges a 3 percent commission on invoices purchased monthly. The interest rate associated with these invoices is 11 percent with interest deductible in advance. If a factor is used, there will be a monthly savings of $1,500 per month in credit department costs. Further, an uncollectible accounts expense of 2 percent on the factored receivables will not exist.
Amount of principal must the company borrow from the bank to receive $400,000 in proceeds is:
Principal / Proceeds = 1.00 / [1.00 – (0.20 – 0.16)
Principal / $400,000 = 1 / (1.0 – 0.36)
$400,000 / (1.0 – 0.36) = $400,000 / 0.64 = $625,000
Amount of accounts receivable must be factored to net the firm $400,000 is:
$400,000 / (1.0 – 0.14) = $400,000 / 0.86 = $465,116
The effective interest rate on the bank loan is:
interest rate / proceeds % = 0.20 / 0.64 = 31.3%
Total annual cost of the bank arrangement is:
Interest ($400,000 x 0.313) = $125,200
Credit costs ($1,500 x 12) = $ 18,000
Uncollectible accounts ($465,116 x 0.02) = $ 9,302
Total annual cost = $152,502
The effective interest rate associated with the factoring arrangement is:
0.11 / 0.86 = 12.8%
The total annual cost of factoring is:
Interest ($400,000 x 0.128) = $51,200
Factoring ($465,116 x 0.03) = $13,953
Total annual cost = $65,153
Bank Loans Vs Factoring Case Example-4
Works-Wealth-Wisely Corporation’s factor charges a 4 percent monthly fee. The factor lends Works-Wealth-Wisely up to 85 percent of receivables purchased for an additional 1.5 percent per month. The monthly credit sales are $350,000. With the factoring arrangement, there is a savings in corporate credit checking costs of $4,200 per month and in bad debts of 3 percent on credit sales.
Wealth Bank has offered to lend Works-Wealth-Wisely up to 85 percent of the receivables, at an interest charge of 2.5 percent per month plus a 5 percent processing charge on receivable lending. The collection period is 30 days, and Works-Wealth-Wisely borrows the maximum amount permitted each month. Should Works-Wealth-Wisely Corporation accept the bank’s offer?
Step-1. Calculate the Cost of factor:
Purchased receivables (0.04 x $350,000) = $14,000
Lending fee (0.015 x $350,000 x 0.85) = $ 4,463
Total cost = $18,463
Step-2. Calculate Cost of bank financing:
Interest (0.025 x $350,000 x 0.85) = $ 7,438
Processing charge (0.05 x $350,000 x 0.85) = $14,875
Additional cost of not using factor:
Credit costs = $ 4,200
Bad debts (0.03 x $350,000) = $10,500
Total Cost = $37,013
Decision: Works-Wealth-Wisely Corporation should stay with the factor, since the cost of the bank’s offer is more than twice the cost of factoring.
However, when compared to long-term financing, short-term financing has several advantages; for example, it is easier to arrange, it is less expensive, and it affords the borrower more flexibility. The drawbacks of short-term financing are that interest rates fluctuate more often, refinancing is frequently needed, and delinquent repayment may be detrimental to the credit rating of a borrower who is experiencing a liquidity problem.