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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.
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