What is factoring,its advantages,disadvantages and how to compute the maximum amount of loan or advance by factoring the Accounts Receivable

What is factoring?

• <!–[if !supportLists]–> <!–[endif]–>A source of short term working capital financing where a company sells its accounts receivable to a factoring company.

• <!–[if !supportLists]–> The factoring company is normally a bank or finance company which provides specialized services relating to credit investigation, sales ledger management, purchase and collection of debts, credit protection as well as provision of finance against receivables and risk bearing.

• <!–[if !supportLists]–> <!–[endif]–>The maximum loan that the firm may get from the factor is the face value of its factored accounts less the factor’s fee (usually 1 to 3%), a reserve(6 to 10%) and interest on loan.

Advantages of factoring:

• <!–[if !supportLists]–> <!–[endif]–>There is no repayment of the borrowing as the accounts receivables are converted into cash

• <!–[if !supportLists]–> Factoring provides a definite pattern of cash inflows

• <!–[if !supportLists]–> Extremely useful source of short term funding for the working capital of the firm as it is very flexible and can tie to the company’s sales expansion.

• <!–[if !supportLists]–> Relieving the borrowing firm of substantially credit and collection costs and considerably part of cash management.

Disadvantage of factoring:

• <!–[if !supportLists]–> <!–[endif]–>As a means of financing it is comparatively a costly source of financing as its cost of financing is higher than the normal lending rate.

Illustration No 1: Computation of the Maximum loan or advances

Question:

Company XYZ has factored $500,000 of its accounts receivable with a 60 day credit term. The factor charges a 1.75% fee, a 7.5% reserve and interest at 2% per month on advances. What is the maximum loan or

advance that the firm can receive from the factor?

Suggested solution:

Face value of accounts receivable $500,000

Less: Fee(0.0175 x $500,000) (8,750)

Reserves( 0.075 x $500,000) (37,500)

Interest(0.02 x $453,750 x 2 months) (18,150)

MAXIMUM loan or advance $435,600

Effective cost of credit = ($18,150 +$8,750) /$435,600 x 360/60

=0.3705

=37.05%