Illustration : Accept Factoring Or Accept Bank Offers

Question:

Company XYZ has a yearly sales turnover of $60 million of which 80% is on credit. Debtors are allowed one month to settle the debt. A factor is willing to advance 90% of the bills raised on credit for a fee of 2% a month plus a commission of 4% on the total amount of debts.

Company XYZ as a result of this arrangement is likely to save $24,000 annually in management costs and avoid bad debts at 1% on the credit sales.

A bank has also approached the company to lend an advance equal to 90% of the debts at an interest rate of 18% per annum. However, its processing fee will be at 2% on the receivables.

Which sources of financing should Company XYZ choose?

Suggested solution:

Cost of factoring:

(a) Fee of 2% on 90% of $4,000,000 $72,000

(80% x 60m=48m/12 =$4m(monthly sale)

(b) Commission of 4% on $4,000,000 $160,000

Less:

(a) Savings if decision to factor(24,000/12) ($2,000)

(b) Savings from bad debts(1% x$4,000,000) ($40,000)

NET COST in Factoring $190,000

Cost of Bank borrowing:

(a) Interest at 18% per annum for one month on

90% of $4,000,000 $54,000

(b) Processing fee 2% x $4,000,000 $80,000

© Bad debts cannot be avoided $40,000

NET COST using bank borrowings $174,000

Since the cost of using bank borrowing is cheaper than the company should use this instead of factoring.