Question

1. Company KPC has an average trade receivables of $1,500,000 and annual sales of $4.5 million. It is considering the use of factoring given that this would result in a reduction in credit control costs of $185,000 per annum. The factoring house charges a fee of 1.3% of sales. It will provide an advance to the company of 85% of its receivables and will charge interest on this advance of 9.6% per annum.

Required: Assess whether it is financially beneficial for company KPC to enter into this factoring arrangement.

Answer 1

To calculate this we follow below steps

Step-1 Calculation of Average collection period ( As not given in this question without that interest cost calculation not possible)

Step-2 Calculate rate of factor's reserve

Step-3 Calculate commission and interest will be charged by factoring firm

Step-4 Calculate annual charges of factoring firm

Step-5 Calculate benefit from factoring service.

Step-6 Conclusion.

To calculate the factoring cost first we require the average collection period

Step-1 Calculation of average collection period

Average Collection Period = Average Trade Receivable / Annual Sales = ($1.5 M / $4.5 M) x 12 Months = 4-Months

Now we calculate factoring reserve %

Step-2 Calculation of factor's reserve

Factor's Reserve = 100% - Advance = 100% - 85% = 15% (Reserve by the Factor on average collection)

Step-3

Now we calculate the commission and Interest will be charged by factoring firm.

Particular	Calculation	Amount
Average Trade Receivable	Given	$ 1,500,000
Less : Factoring Commission	$1,500,000 x 1.3%	$        19,500
Less : Factoring Reserve	$1,500,000 x 15%	$     225,000
Amount available for advance	$1,500,000 - $19,500 - $225,000	$ 1,255,500
Factor will deduct interest @ 9.6%	$1,255,500 x 9.6% x 4/12 months	$        40,176
Advance to be paid	$1,255,500 - $40,176	$ 1,215,324

Step-4

This factoring commission and interest charges is for 4-months so we require to calculate the annual cost

Annual Cost of factoring
Particular	Calculation	Amount
Factoring Commission	$19,500 x 12/4 Months	$        58,500
Interest Charges	$40,176 x 12/4 Months	$     120,528
Total Cost	$58,500 + $120,528	$     179,028

Step-5

Now we calculate benefit from factoring service

Benefit from Factoring	Amount
Reduction in credit control cost	$     185,000
Less : Factoring cost	$     179,028
Net Benefit	$          5,972

Conclusion : As the benefit from factoring service more than '0' (Zero) i.e. $5,972, So it is financially beneficial for company KPC to enter into this factoring arrangement.