Connect with us

Factoring Vs Receivable Financing Analysis

Published

on

Factoring Vs Accounts Receivable FinancingAccounts receivable may be financed under either a factoring or receivable financing [or “assignment (pledging) arrangement“]. Should I use factoring or receivable financing to finance my company? Which is the better option? There is no straight forward answer for the questions. Factoring avoids the need for long-term financing and generates recurring cash flow. However, there are high administrative costs when many small accounts exist. In accounts receivable financing, the accounts receivable are the collateral for the loan as well as the source of repayment.

I discuss both financing alternatives [factoring vs receivable financing] in some analysis through this post. Enjoy! 

Advertisement

 

Factoring Vs Receivable Financing 

Factoring is the sale of accounts receivable to a finance company without recourse. The purchaser assumes all credit and collection risks. The amount received equals the face value of the receivables less the commission charge, which is usually 2 to 4 percent higher than the prime interest rate. The cost of factoring 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 risk exists. Customer payments are made directly to the factor.

 

Advantage and Disadvantage Of Factoring

  • The advantages of factoring are immediate availability of money, reduction in overhead since the credit examination activity is no longer needed, obtaining financial advice, receipt of seasonal advances, and strengthening of the balance sheet position.
  • The disadvantages of factoring are the high cost and the customer’s negative impression because of the change in ownership of the receivables. Furthermore, factors may antagonize customers by their demanding collection methods of delinquent accounts.

 

In a receviable financing [assignment (pledging)], 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 company incurs a service charge, interest on the advance, and bad debt losses. Customer remissions continue to be made directly to the company.

The assignment of accounts receivable [receivable financing] has the advantages of immediate availability of cash, cash advances available on a seasonal basis, and avoidance of negative customer reaction. The disadvantages include the high cost, the continuance of clerical work on the accounts receivable, and the bearing of all credit risk.

A controller [or CFO] has to recognize the impact of a change in accounts receivable policy on the cost of financing receivables. The cost of financing may rise or fall under different conditions. For example:

  • when credit standards are eased, costs rise;
  • when recourse for defaults is given to the finance company, costs decrease; and
  • when the minimum invoice amount of a credit sale is increased, costs decline.

 

Before analyzing the choices [whether to use factoring or receivable financing], let’s see what the cost of factoring arrangement on the following section. Read on…

 

Calculating Cost Of Factoring Arrangement

A factor will purchase the company’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 × ($120,000 × 12)]              = $21,600
Cost of borrowing [0.14 × ($120,000 × 0.8)]  =   13,440
Total cost                                                        = $35,040

 

Factoring Vs Receivable Financing Analysis-1

A factor charges a 3 percent fee per month. The factor lends the company up to 75 percent of receivables purchased for an additional 1 percent per month. 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 to lend the company 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.

If the company borrows the maximum per month, should it stay with the factor or switch to XYZ Bank?

Cost of factor:
Purchased receivables (0.03 × $400,000)           = $12,000
Lending fee (0.01 × $300,000)                           =     3,000
Total cost                                                           = $15,000

Cost of bank financing:
Interest (0.02 × $300,000)                                 = $  6,000
Processing charge (0.04 × $300,000)                =  12,000

Additional cost of not using the factor:
Credit costs                                                       =    6,500
Bad debts (0.02 × $400,000)                             =     8,000
Total cost                                                          = $32,500

Conclusion: The company should stay with the factor.

 

Factoring Vs Financing Receivable Analysis-2

A company needs $250,000 and is considering 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 per- cent. 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, the company 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 option?

The bank loan that will net the company its desired $250,000 in proceeds is:

= Proceeds/(100% – Proceeds deducted)
= $250,000/[100% – (18% + 20%)]
= $250,000/(1.0 – 0.38)
= $250,000/0.62
= $403,226

The effective interest rate of the bank loan is:

Effective interest rate
= Interest rate /Proceeds(%)
= 0.18/0.62
= 29.0%

The amount of accounts receivable that should be factored to net the ?rm $250,000 is:

= $250,000/(1.0 – 0.16)
= $250,000/0.84
= $297, 619

 

The total annual cost of the bank arrangement is:

Interest ($250,000 × 0.29)                                           = $72,500
Additional cost of not using a factor:

Credit costs ($1,000 × 12)                                          =  12,000

Uncollectible accounts ($297,619 × 0.03)                  =   8,929

Total cost                                                                   = $93,429
The effective interest rate associated with factoring accounts receivable is:

Effective interest rate = 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 × 0.143) = $35,750
Factoring ($297,619 × 0.04) =  11,905
Total cost                             = $47,655

Conclusion: The factoring arrangement should be selected because it costs almost half as much as the bank loan.

 

Receivable Financing Vs. Factoring Analysis-3

A company is examining a factoring arrangement. The company’s sales are $2.7 million, accounts receivable turnover is nine times, and a 17 percent reserve on accounts receivable is required. 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 of receivables after subtracting the commission charge and reserve. The interest charge reduces the advance. The annual effective cost under the factoring arrangement is computed next.

Average accounts/receivable:

= Credit sales/Turnover
= $2,700,000/9
= $300,000

The company will receive the following amount by factoring its accounts receivable:

Average accounts receivable      = $300,000
Less: Reserve ($300,000 × 0.17)       =   (51,000)
Commission ($300,000 × 0.02)        =    ( 6,000)
Net prior to interest                    = $243,000
Less: Interest ($243,000 × (16%/9)   =     (4,320)
Proceeds received                             = $238,680

 

The annual cost of the factoring arrangement is:

Commission ($300,000 × 0.02)    = $   6,000
Interest ($243,000 × (16%/9)        =      4,320
Cost each 40 days (360/9)            = $ 10,320
Turnover                                           ×         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%

Click to comment

Leave a Reply

Your email address will not be published. Required fields are marked *




Are you looking for easy accounting tutorial? Established since 2007, centre-potential.ru hosts more than 1300 articles (still growing), and has helped millions accounting student, teacher, junior accountants and small business owners, worldwide.

Trending


Related pages


dilutive shareswac methodincome tax appeal letter samplesample of a promissory note for personal loanrop eoqwhen are product costs expensedadvertising expense on balance sheetcost of goods manufactured formulathe matching principlereal estate promissory note templatewhat is provision for doubtful accountshow to construct a cash flow statementadvantages and disadvantages of forecastingexplain the accounting cycletreasury stock stockholders equityindirect material in manufacturing processfx translationunconsolidated subsidiariesexample of overhead costmeaning deferred revenue expenditure give examplespromissory note format pdfaccounts receivable days sales outstandingoverhead expenses definitionaudit simulationsfraudulent misstatementcapital stock journal entryhow hard is the cpa examstereotypes of accountantsexamples of deferred tax assets and liabilitieshow to compute depreciation expensereinsurance accounting entriesapplied overhead ratesubcontractor accountingcoso standarddepreciation of office equipmentcpa practice examincome stmtaccrued expense adjusting entryeitf 01-9regulation s-x secfavorable and unfavorable variancespremium bonds accountaccounts payable days calculationdebit and credit definition accountingsimple safety stock calculationcaterpillar financial statementstotal stockholders equitywhat is a goodwill impairment chargedebt extinguishmentpromissary note sampleprepaid expenses definitionwriting a letter to irs to remove penaltiesaccounting entries for sale of businessaudit workpapercash receipts and disbursementsdiscount allowed in income statementhow to calculate cgs481 a adjustment calculationcalculate depreciation using straight line methodias 19 vs us gaapinvestment in accounts receivable formuladupont accountingcost of goods manufactured formula accountingdepreciation useful life gaapstartup expenses and capitalizationapplied factory overheadowners equity meansafs securities accountingtotal asset turnover calculationdcf formulaaccounts receivable equationsplit excel columnsprocess costing calculationdefine departmental accountingbreak even calculation excelis prepaid insurance a deferralcapitalization of software licensesrumus cash ratio