Question

Raphael Ltd. is a small engineering business that has annual credit sales revenue of $2.4 million. In recent years, the business has experienced credit control problems. The average collection period for sales has risen to 50 days even though the stated policy of the business is for payment to be made within 30 days. In addition, 1.5% of sales are written off as bad debts each year. The accounts receivable are currently financed through a bank overdraft, which has an interest rate of 12% a year.

The business has recently communicated with a factor that is prepared to make an advance to the business equivalent to 80% of receivables, based on the assumption that customers will, in future, adhere to a 30-day payment period. The interest rate for the advance will be 11% a year. The factor will take over the credit control procedures of the business and this will result in a saving to the business of $18,000 a year; however, the factor will charge 2% of sales revenue for this service. The use of the factoring service is expected to eliminate the bad debts incurred by the business.

Required:

Calculate the net cost of the factor agreement to the business and state whether the business should take advantage of the opportunity to factor its accounts receivables.

Answer 1

Savings to the firm	Computation	Amount
Cost of credit administration	Given	$           18,000
Interest on bank overdraft	$2,400,000*12%	$         288,000
Cost of bad debts	$2,400,000*1.5%	$           36,000
Total savings		$         342,000
Cost to the firm
Factoring commission	$2,400,000*2%	$           48,000
Interest charges	$2,400,000*80%*11%	$         211,200
Total costs		$         259,200
Net benefit to the firm		$           82,800

Since the benefit is more than cost, hence factoring is better.