Question

1. Because of expansion, Khan Enterprises (KE) is in dire need of working capital and is considering factoring as an alternative. A factor, will offer the firm a “non-recourse” arrangement that will require a 10% reserve for returns and allowances and a 2.5% factoring commission or fee. It will advance the funds at 2.0% above prime.

The company’s sales average $36 million with DSO of 50 days. Bad-debt losses average $15,000 a month and the company will further save $4,000 per month by eliminating its credit department.

Which alternative should the company select?

Are there any qualitative factors the company should consider?

Answer 1

Given information:
	Debtor turnover (DSO)	50 days
	Sales	$   3,60,00,000
	Bad debt losses per month	$           15,000
	Savings per month by eliminating the credit dept.	$             4,000
	Factoring arrangement	Non-recourse
	Reserve for returns and allowances	10%
	Factoring commission	2.50%
	Funds advanced	2% above prime
	If factoring arrangement is not entered into
	Particulars	Amount
a.	Sales	$   3,60,00,000
b.	DSO	50 days
c.	Receivables (a*b/365)	$      49,31,507
d.	Less: Bad debts ($15,000 per month*12 months)	$        1,80,000
e.	Less: Administration costs ($4,000 per month*12 months)	$           48,000
f.	Net received by the company (c-d-e)	$      47,03,507
g.	Cost of current admin to the company ((d+e)/f*100)	4.85%
	If factoring arrangement is entered into
		Factor collects fees
		In advance	In arrears
	Particulars	Amount	Amount
I.	Money raised -
a.	Sales	$   3,60,00,000	$3,60,00,000
b.	DSO	50 days	50 days
c.	Receivables (a*b/365)	$      49,31,507	$   49,31,507
d.	Less: Reserve @ 10%	$        4,93,151	$     4,93,151
e.	Money borrowed from factor (c-d)	$      44,38,356	$   44,38,356
f.	Factoring fee @ 2.50%	$        1,10,959	$                -
g.	Net of fees (e-f)	$      43,27,397	$   44,38,356
h.	Interest @ 2% above prime ((5%+2%)*g)	$        3,02,918	$                -
i.	Net received	$      40,24,479	$   44,38,356
II.	Costs -
j.	Factoring fee @ 2.50% paid	$        1,10,959	$     1,10,959
k.	Interest paid	$        3,02,918	$     3,02,918
l.	Bad debts saved ($15,000 per month*12 months)	$        1,80,000	$     1,80,000
m.	Administration costs saved ($4,000 per month*12 months)	$           48,000	$        48,000
n.	Net costs (j+k-l-m)	$        1,85,877	$     1,85,877
III.	Net money raised (e-n)	$      42,52,479	$   42,52,479
IV.	Cost of factoring to the company (n/i*100)	4.62%	4.19%
	Note 1: We assume that the financial year is of 365 days
	Note 2: We assume that the prime lending rate is 5%, since no information has been provided in the question

The company should enter into the factoring arrangement, since the cost to the company due to factoring is lower than the cost it continues as per the current administration of the credit department.

The qualitative factors to be considered by the company are:

1. As shown above, the cost to the company will differ if the factor collects the fees and interest owed in advance or in arrears.

2. Since the arrangement is without recourse, the company will benefit if it makes maximum efforts to convert its bad debts into receipts, before entering into the arrangemet.

3. If the prime lending rate is above 5%, as assumed above, the cost of factoring to the Company would be higher than the cost of administration.