Question

In order to convert Account Receivable into faster cash, a company can sell its accounts receivable to another company, called a factor, at a discount. Assume your average credit sales are $50 million per year and average accounts receivable are $5 million. A factoring company offers you an agreement that it will be buying your accounts receivable at a 2.20% discount. Your bank offers you a credit at R% per year (actual yearly rate). What would be the minimum R% for which you would choose factoring? That is, what is the rate R% offered by the bank at or below which you would rather borrow money from the bank instead of factoring? Express your answer as a percentage.

Answer 1

Formula to calculate accounts receivable collection period
Collection period = (Average accounts receivable/Average credit sales)*365
Assuming 365 days in a year
Collection period is the number of days it takes to collect cash from the customer for the sales made on credit.
Collection period = ($5 million/$50 million)*365
Collection period	36.50	days
The discount rate offerred by factor is 2.20% for 36.50 days where accounts receivable are outstanding.
Therefore we would find the annual discount rate that is for 365 days.
Calculation of annual discount rate
((1+(2.20%/36.50))^365) - 1
((1.000603^365)-1
24.60%
The factoring costs is 24.60% annually and so if the bank offers interest rate of 24.60% or below this rate than the bank borrowing would be preferred than factoring.