FMF9
Syllabus C. Working Capital Management C2d. Management of receivables

Debt Factor 3 / 5

Types of Arrangement

A factor can work in different ways…

It can simply be they take over a company’s credit control department for a fee

It may be that the factor forwards the company some money in advance, and then collects the money from the debtors themselves and keeps the money.

The amount forwarded here would be like a loan and so the factor would also charge interest

Finally, if the factor does “buy” the company’s debts then the deal may be “with recourse” or “without recourse”

  1. With Recourse - Any bad debts get returned to the company

  2. Without Recourse - Any bad debts are suffered by the Factor

Advantages Disadvantages
Admin Costs Saved Can be expensive
Gets Cash Quickly Could lose customer goodwill
More cash available as sales grow May give a bad impression to customers

How to do the numbers…

Compare:

  • Current cost (Receivables x overdraft rate)

  • New cost with Factor (New receivables x overdraft rate, Fee, net cost of forwarding money less any increase in contribution, less admin savings)

Illustration

A Company has credit sales of 200,000pa. Credit term is 30 days. The factor offers to buy 80% at an interest rate of 9%. The company can get an overdraft for 6%. The factor charges 1.5% of current credit sales.

The factor will offer customers an early settlement discount if paid in 15 days, 40% will accept this and the remainder will take 50 days to pay. Sales will increase by 5% and contribution to sales ratio is 40%

Should the factor’s offer be accepted?

Solution

  • Current cost 

    Receivables = 30/365 x 200000 =16,438
    These are financed by an overdraft at 6% = 986

    TOTAL = 986

  • Cost of Factoring 

    New receivables = New sales x 15/365 x 40% = 3,452
    New receivables = New sales x 50/365 x 60% = 17,260
    Financed by overdraft cost at 6% = 1,242
    Factor Fee = 200,000 x 1.5% = 3,000
    Increase in contribution = sales increase x 40% = (4,000)
    Forward Cost = new receivables x 80% x (9-6%) = 497.10

    TOTAL = 739.1

  • The factor option costs less - so the factor’s offer should be taken up

Tricky bits

Forwarding of cash from Factor

  • You will notice in the question above, I didn’t add the full cost of this forwarding money (like a loan). 

    What I did was take the forwarding interest rate charged less the overdraft interest rate.

  • Think of it like this, the company has an overdraft of 6%. Then they get loaned some money for 9%. 

    They will put the money from the loan in the bank and so it will lower their overdraft. 

    This means they will be saving 6%. Therefore the net cost to them is 3%.

  • So always take the net cost of the forwarding interest rate less the overdraft rate

Bad Debts

  1. With recourse

    No change here then (the company still keeps the bad debt risk). Therefore, generally, as theres no change - keep bad debts completely out of the workings. Easy-peasy-lemon-squeezy

    Just be careful though if it stays with recourse but the bad debts reduce - in that case treat this as a saving in the factor policy

  2. Without recourse

    Here the company gives its bad debts risk to the factor. Therefore this is a saving for the company if they choose the factor option. 

    So treat it like this - show as a saving in the factor option