Accounts receivable financing
has several advantages, including avoiding the need for long-term financing and
obtaining a recurring cash flow base. Accounts receivable financing has the
drawback of high administrative costs when there are many small accounts.
However, with the use of computers these costs can be curtailed. Accounts
receivable may be financed under either a “factoring“ or “assignment arrangement“.
Factoring refers to the outright sale of accounts receivable to a bank or
finance company without recourse.
The purchaser takes all credit and collection risks. The proceeds received by
the selling company are equal to the face value of the receivables less the
commission charge, which is typically 2 to 4 percent higher than the prime interest rate. The cost of the factoring arrangement is the
factor’s commission for credit investigation, interest on the unpaid balance of
advanced funds, and a discount from the face value of the receivables where
high credit risks exist. Remissions by customers are made directly to the
factor.
The advantages of factoring include:- Immediate availability of cash
- Reduction in overhead since the credit examination function is no longer required
- Utilization of financial advice
- Receipt of advances as needed on a seasonal basis
- Strengthening of the balance sheet position
The drawbacks to factoring include both
the high cost and the poor impression left with customers because of the change
in ownership of the receivables. Also, factors may antagonize
customers by their demanding methods of collecting delinquent accounts. In an
assignment, there is no transfer of the ownership of the accounts receivable.
Receivables are given to a finance company
with recourse. The finance company typically advances between 50 and
85 percent of the face value of the receivables in cash. The borrower is
responsible for a service charge, interest on the advance, and any resulting
bad debt losses. Customer remissions continue to be made directly to the
company.
The assignment of accounts receivable has
a number of advantages, including the immediate availability of cash, cash
advances available on a seasonal basis, and avoidance of negative customer
feelings. The disadvantages include the high cost, the continuance of
the clerical function associated with accounts receivable, and the bearing of
all credit risks.
The financial manager should be aware of
the impact of a change in accounts receivable policy on the cost of financing
receivables.
When accounts receivable are financed,
the cost of financing may rise or fall under different conditions. For
instance: (1) when credit standards are relaxed, costs increase; (2) when
recourse for defaults is given to the finance company, costs decrease; and (3)
when the minimum invoice amount of a credit sale is increased, costs decrease.
The finance manager should compute the
cost of accounts receivable financing and select the least
expensive alternative.
A factor will purchase Ryan Corporation’s
$120,000 per month accounts receivable. The factor will advance up to
80 percent of the receivables for an annual charge of 14 percent, and a 1.5
percent fee on receivables purchased. The cost of this factoring arrangement
is:
Factor fee [0.015 x ($120.000 x 12)] = $21,600Cost of borrowing [0.14 x ($120,000 x 0.8)] = $13,440
Total cost = $35,040
Example
Lie Dharma 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, Lie Dharma 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 Lie Dharma?
= Proceeds / [100% - (percent deducted)]
= $250,000/ (100% - (18% + 20%)]
= $250,000 / (1 - 0.8)
= $250,000 / 0.62
= $403,226
The effective interest rate associated with the bank loan is:
= 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 x 0.16]
= $250,000 / 0.84
= $297,619
The total annual cost of the bank arrangement is:
Interest ($250,000 x 0.29) = $72,500
Additional cost of not using a factor:
Credit costs ($1,000 x 12) = $12,000
Uncollectible accounts ($297,619 x 0.03) = $ 8,929
Total cost =$93,429
The effective interest rate associated with factoring accounts receivable is:
= 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 x 0.04) = $11,905
Total cost = $47,65
Factoring should be used since it will cost almost half as much as the bank loan.
Example
Putra
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.
Cost of factor:
Purchased receivables (0.03 x $400,000) = $12,000
Lending fee (0.01 x $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 (0.02 x $400,000) = $ 8,000
Total cost = $32,500
Putra Corporation should stay with the factor.
Example
Dharma Company is considering a factoring
arrangement. The company’s sales are $2,700,000, accounts receivable turnover
is 9 times, and a 17 percent reserve on accounts receivable is required by the
factor.
The factor’s commission charge on average
accounts receivable payable at the point of receivable purchase is 2.0 percent.
The factor’s interest charge is 16 percent on receivable after subtracting the commission
charge and reserve. The interest charge reduces the advance.
Average accounts receivable:
= credit sales / turnover
= $2,700,000 / 9
= $300,000
Dharma will receive the following amount by factoring its accounts receivable:
Average accounts receivable = $300,000
Less: Reserve ($300,000 x 0.17) = -51,000
Commission ($300,000 x 0.02) = -6,000
Net prior to interest = $243,000
Less: Interest [$243,000x(16%/9)] = $ 4,320
Proceeds received = $238,680
The annual cost of the factoring arrangement is:
Commission ($300,000 x 0.02) = $ 6,000
Interest [$243,000 x (16%/9)] = $ 4,320
Cost each 40 days (360/9) = $10,320
Turnover x 9
Total annual cost = $92,880
The annual effective cost under the factoring arrangement based on the amount received is:
= Annual cost / Average amount received
= $92,880 / $238,680
= 38.9%
Source: http://accounting-financial-tax.com/2010/04/accounts-receivable-financing-factoring-vs-bank-financing/
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