FACTORING. Net Advantage of factoring = Rs.(2,15,753 2,00,000) = Rs.15,753 Decision: As there is net savings, factoring is preferable.

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1 FACTORING Pen Pusher FACT1 A company is considering engaging a factor. The following information is available: a) The current average collection period for the company s debtor is 80 days. ½% of debtors default. The factor has agreed to pay money due after 60 days and will take the responsibility of any loss on account of bad debts. b) The annual charge for the factoring is 2% of turnover payable annually in arrears. Administration cost savings is likely to be Rs.1,00,000 p.a. c) Annual sales, all on credit, are Rs.1,00,00,000. Variable cost is 80% of sales price. The company s cost of borrowings is 15% p.a. Should the company enter into a factoring agreement? 1 year = 365 days. Hint of Pen Pusher FACT1 Factor is not giving any loan to the company. No question of interest on loan. There is reduction of debt collection period, so there would be savings of interest. As variable cost information is given in the problem, Investment in debtors should be considered at cost and not at sale value. Advantage of factoring are as follows: Reduction in debt collection period = = 20 days Savings in Bad Debt Loss Savings in administrative cost Associated Cost of factoring are as follows: Factoring Charge Solution of Pen Pusher FACT1 Determination of Net Cost / Net Advantage of Factoring Factoring Charge [ 1,00,00,000 X 2% ] 2,00,000 Savings in Interest due to reduction in debt collection period [1,00,00,000 X 20 / 365 X 80% X 15%] 65,753 Savings in Bad Debt loss [ 1,00,00,000 X ½% ] 50,000 Savings in Administrative Cost 1,00,000 Total Savings 2,15,753 Net Advantage of factoring = Rs.(2,15,753 2,00,000) = Rs.15,753 Decision: As there is net savings, factoring is preferable. Page - 1 of 8

2 Pen Pusher FACT2 A Ltd. has total sales of Rs.4.50 crore and its average collection period is 120 days. The past experience indicate that bad debt losses are 2% on sales. The expenditure incurred by the company in administering its receivables collection are Rs.6,00,000. A factor is prepared to buy the company s receivables by charging 2% commission. The factor will pay advance on receivables to the company at an interest rate of 18% p.a. after withholding 10% as reserve. Assume 1 year = 360 days. You are required to calculate effective cost of financing to the company. Hints of Pen Pusher FACT2 In this case factor is giving loan to A Ltd. So, there would be interest cost. There is no reduction of debt collection period, so no savings of interest. It is better to assume non-recourse factoring. It has been assumed that interest is upfront. Advantage of factoring are as follows: Savings in Bad Debt Savings in administrative cost Associated cost of factoring are as follows: Interest Cost Commission Solution of Pen Pusher FACT2 Receivables = Rs.4,50,00,000 X 120 / 360 = Rs.1,50,00,000 Reserve = Rs.1,50,00,000 X 10% = Rs,15,00,000 Commission = Rs.1,50,00,000 X 2% = Rs.3,00,000 Gross Advance = Rs.(1,50,00,000 15,00,000 3,00,000) = Rs.1,32,00,000 Interest for 120 days = Rs.1,32,00,000 X 18% X 120/360 = Rs.7,92,000 Net Advance = Rs.(1,32,00,000 7,92,000) = Rs.1,24,08,000 Determination of Annualized Net Cost of Factoring Annualized Commission [3,00,000 X 360/120] 9,00,000 Annualized Interest Cost [7,92,000 X 360/120] 23,76,000 Less: Savings in Bad Debt Loss p.a. [4,50,00,000 X 2%] (9,00,000) Less: Savings in Administrative Cost p.a. (6,00,000) Net Cost of Factoring p.a. 17,76,000 Effective Rate of Cost to the firm = [17,76,000 / 1,24,08,000] X 100 = 14.31% p.a. Page - 2 of 8

3 Pen Pusher FACT3 The credit sales and receivables of M Ltd. at the end of the year are estimated at Rs.3,74,00,000 and Rs.46,00,000 respectively. The average variable overdraft interest rate is 5%. M Ltd. is considering a proposal for factoring its debt on a non-recourse basis at an annual fee of 3% on credit sales. As a result, M Ltd. will save Rs.1,00,000 per year in administrative cost and Rs.3,50,000 as bad debts. The factor will maintain a receivables collection period of 30 days and advance 80% of the face value thereof at an annual interest rate of 7%. Evaluate the validity of the proposal. NOTE: 365 days are to be taken in a year for the purpose of calculation of receivables. Hints of Pen Pusher FACT3 Present Receivable is given. Debt collection period under factoring is given. So, we can calculate receivable under factoring. Difference in b/w these two variable would give surplus fund. Based on surplus fund, we can calculate savings in interest cost. It has been assumed that overdraft interest rate is 5% p.a. It has been assumed that there is no upfront payment. It has been asked the validity of the proposal. For this purpose, we have to consider interest cost of the loan taken from other than factor i.e. Bank Overdraft in the present 5% p.a. Advantage of factoring are as follows: Savings in Bad Debt Savings in administrative cost Savings in Interest Cost arising from reduction in receivables Associated cost of factoring are as follows: Interest Cost Commission Solution of Pen Pusher FACT3 Existing Receivables = Rs.46,00,000 Receivables under Factoring = Rs.3,74,00,000 X 30/365 = Rs.30,73,973 Decrease in Receivables = Rs.(46,00,000 30,73,973) = Rs.15,26,027 Savings in Interest Cost = Rs.15,26,027 X 5% = Rs.76,301 Advance = Rs.30,73,973 X 80% = Rs.24,59,178 Additional Interest Rate on Advance by Factor = 7% - 5% = 2% Additional Interest on Advance from Factor = Rs.24,59,178 X 2% = Rs.49,183 TUTORIAL NOTE In this problem it is directly stated that advance is 80% of receivables. So, Gross Advance would be 80% of Receivables AND NOT Receivables Reserve Commission. Page - 3 of 8

4 Evaluation of Validity of Factoring Proposal Additional Interest on Advance from Factor 49,183 Charges payable to Factor [3,74,00,000 X 3%] 11,22,000 Less: Savings in Bad Debts (3,50,000) Savings in Administrative Cost (1,00,000) Savings in Interest Cost arising from reduction in Bad Debts (76,301) Net Cost of Factoring 6,44,882 As there is a Net Cost of Factoring, the proposal is not acceptable. Pen Pusher FACT4 A Ltd. with a turnover of Rs.4.80 crore is expecting growth of 25% for forthcoming year. Average credit period is 90 days. The past experience shows that bad debt losses are 1.75% on sales. The company s administering cost for collecting receivables is Rs.6,00,000. It has decided to take factoring services on terms that factor will buy receivables by charging 2% commission and 20% risk with recourse. The factor will pay advance on receivables to the firm at 16% interest rate p.a. after withholding 10% as reserve. Calculate the effective cost of factoring to the firm. (Assume 360 days a year). Hints of Pen Pusher FACT4 20% risk with recourse means out of the total Bad Debts, 20% would be borne by customer. Otherwise, we can say customer would save 80% of Bad Debts Solution of Pen Pusher FACT4 Expected Turnover = Rs.4.80 crore + 25% = Rs.6 crore Receivables = Rs.6 crore X 90 / 360 = Rs.1.5 crore Reserve = Rs.1.5 crore X 10% = Rs.0.15 crore Commission = Rs.1.5 crore X 2% = Rs.0.03 crore Gross Advance = Rs.( ) crore = Rs.1.32 crore Interest for 90 days = Rs.1.32crore X 16% X 90 / 360 = Rs crore Net Advance = Rs.( ) crore = Rs crore Determination of Effective Cost of Factoring Commission [0.03 X 360 / 90] 0.12 Interest [ X 360 / 90] Less: Savings in Administrative Cost (0.06) Page - 4 of 8

5 Savings in Bad Debts [6 X 1.75% X 80%] (0.084) Net Cost of Factoring Effective Cost of Factoring = X 100 / = 14.77% p.a. Pen Pusher FACT5 B Ltd. manages its accounts receivables internally by its sales and credit department. The cost of sales ledger administration stands at Rs.10 crore annually. The company has a credit policy of 2/10 net 30. Past experience of the company has been that on an average 40 per cent of the customers avail of the discount by paying within 10 days while the balance of the receivables are collected on average 90 days after the invoice date. Bad debts of the company are 1.5 per cent of total sales. The projected sales of the next years are Rs.1,000 crore. B Ltd. finances its investments in debtors through a mix of bank credit and own long term funds in the ratio of 70 : 30. The current cost of bank credit and long term funds are 13 per cent and 15 per cent respectively. With escalating costs associated with the in house management of debtors coupled with the need to unburden the management with the tusk so as to focus on sales promotion, the company is examining the possibility of outsourcing its factoring service for managing its receivables and has two proposals on hand with a guaranteed payment within 30 days. The main elements of the Proposal 1 from Fine Bank Factors Ltd. are: Advance, 88 per cent and 84 per cent for the recourse and non-recourse arrangements. Discount charge in advance, 21 per cent for with recourse and 22 per cent without recourse. Commission, 4.5 per cent without recourse and 2.5 per cent with recourse. The main elements of the Proposal 2 from Rough Bank Factors Ltd. are: Advance, 84 per cent with recourse and 80 per cent without recourse respectively. Discount charge up front without recourse 21 per cent and with recourse 20 per cent. Commission upfront, 3.6 per cent without recourse and 1.8 per cent with recourse. The opinion of the Chief Marketing Manager is that in the context of the factoring arrangement, his staff would be able exclusively focus on sales promotion which would result in additional sales of 10% of projected sales. Kindly advice as a financial consultant on the alternative proposals. What advice would you give? Why? Page - 5 of 8

6 Hints of Pen Pusher FACT5 2/10 net 30 means if the payment is made by a customer within 10 days, he would be entitled for a discount of 2%. Otherwise, the payment has to be made within 30 days without any discount. B Ltd. has the following alternatives: In-House Management i.e. No Factoring Fine Bank Factors with recourse Fine Bank Factors without recourse Rough Bank Factors with recourse Rough Bank Factors without recourse For the first alternative, annual sales would be Rs.1,000 crore For the other alternatives, annual sales would be = Rs.1,000cr + 10% = Rs.1,100cr. Solution of Pen Pusher FACT5 In connection with In-House Management, associated costs are as follows: Cash Discount = Rs.1,000cr X 40% X 2% = Rs.8cr Bad Debts = Rs.1,000cr X 1.5% = Rs.15cr Avoidable Administrative Cost = Rs.10cr Cost of Investments in Receivables = Rs.21.61cr [ See working below ] Average Collection Period = 10 X 40% + 90 X 60% = 58 days Investment in Debtors = Rs.1,000cr X 58/365 = Rs cr Cost of Fund Invested in Debtors = 0.70 X x 15 = 13.60% Cost of Investment in Debtors = Rs cr X 13.60% = Rs.21.61cr Evaluation of Fine Bank Proposal Receivables = Rs.1,100cr X 30 / 365 = Rs.90.41cr Commission (with recourse) = Rs.1,100cr X 2.5% = Rs.27.5cr p.a. Commission (without recourse) = Rs.1,100cr X 4.5% = Rs.49.50cr p.a. Gross Advance = Rs.90.41cr X 88% = Rs.79.56cr (with recourse) Gross Advance = Rs.90.41cr X 84% = Rs.75.94cr (without recourse) Discount Charge (with recourse) = Rs.79.56cr X 21% = Rs.16.71cr p.a. Discount Charge (without recourse) = Rs.75.94cr X 22% = Rs.16.71cr p.a. Requirement of Long Term Fund to finance Debtors = Rs.( )cr = Rs.10.85cr (with recourse) Cost of such Long Term Fund = Rs.10.85cr X 15% = Rs.1.63cr p.a. (with recourse) Requirement of Long Term Fund to finance Debtors = Rs.( )cr = Rs.14.47cr (without recourse) Cost of such Long Term Fund = Rs.14.47cr X 15% = Rs2.17cr p.a. (without recourse) Cost of Factoring (with recourse) = Commission + Discount + Cost of Long Term Fund Invested In Debtors = Rs.( )cr = Rs cr Benefit of Factoring (with recourse) = Savings in [Discount + Administrative Cost + Cost of Investment in Debtors] = Rs.[ ]cr = Rs cr. Net Cost of Factoring (with recourse) = Rs.[ ] = Rs.6.23cr. Page - 6 of 8

7 Cost of Factoring (without recourse) = Commission + Discount + Cost of Long Term Fund Invested In Debtors = Rs.( )cr = Rs cr Benefit of Factoring (without recourse) = Savings in [Discount + Bad Debt + Administrative Cost + Cost of Investment in Debtors] = Rs.[ ]cr = Rs cr. Net Cost of Factoring (without recourse) = Rs.[ ] = Rs.13.77cr. Evaluation of Rough Bank Proposal Receivables = Rs.1,100cr X 30 / 365 = Rs.90.41cr Commission (with recourse) = Rs.1,100cr X 1.8% = Rs.19.8cr p.a. Commission (without recourse) = Rs.1,100cr X 3.6% = Rs.39.6cr p.a. Gross Advance = Rs.90.41cr X 84% = Rs.75.94cr (with recourse) Gross Advance = Rs.90.41cr X 80% = Rs.72.33cr (without recourse) Discount Charge (with recourse) = Rs.75.94cr X 20% = Rs.15.19cr p.a. Discount Charge (without recourse) = Rs.72.33cr X 21% = Rs.15.19cr p.a. Requirement of Long Term Fund to finance Debtors = Rs.( )cr = Rs.14.47cr (with recourse) Cost of such Long Term Fund = Rs.14.47cr X 15% = Rs.2.17cr p.a. (with recourse) Requirement of Long Term Fund to finance Debtors = Rs.( )cr = Rs.18.08cr (without recourse) Cost of such Long Term Fund = Rs.18.08cr X 15% = Rs2.71cr p.a. (without recourse) Cost of Factoring (with recourse) = Commission + Discount + Cost of Long Term Fund Invested In Debtors = Rs.( )cr = Rs cr Benefit of Factoring (with recourse) = Savings in [Discount + Administrative Cost + Cost of Investment in Debtors] = Rs.[ ]cr = Rs cr. Net Benefit of Factoring (with recourse) = Rs.[ ] = Rs.2.45cr. Cost of Factoring (without recourse) = Commission + Discount + Cost of Long Term Fund Invested In Debtors = Rs.( )cr = Rs.57.5 cr Benefit of Factoring (without recourse) = Savings in [Discount + Bad Debt + Administrative Cost + Cost of Investment in Debtors] = Rs.[ ]cr = Rs cr. Net Cost of Factoring (without recourse) = Rs.[ ] = Rs.2.89cr. DECISION As there is a net benefit, proposal of Rough Bank with recourse is acceptable. Page - 7 of 8

8 Pen Pusher FACT6 PQR Ltd. has credit sales of Rs.165 crore during the financial year and its average collection period is 65 days. The past experience suggests that bad debt losses are 4.28% of credit sales. Administrative costs incurred in collection of its receivables is Rs.12,35,000 p.a. A factor is prepared to buy the company s receivables by charging 1.95% commission. The factor will pay advance on receivables to the company at an interest rate of 16% p.a. after withholding 15% reserve. Estimate the effective cost of factoring to the company assuming 360 days in a year. Solution of Pen Pusher 6 Receivables = Rs.165 crore X 65 / 360 = Rs crore Reserve = Rs X 15% = Rs crore Commission = Rs X 1.95% = Rs crore Gross Advance = Receivables Reserve Commission = Rs.( ) crore = Rs crore Interest for 65 days = Rs X 16% X 65/360 = Rs.7148 crore Net Advance (assuming interest upfront) = Rs.( ) crore = Rs crore. Determination of Annual Net Cost of Factoring Commission [ X 360 / 65 ] Interest [ X 360 / 65 ] Less: Savings in Administrative Cost (0.1235) Savings in Bad Debts [ 165 X 4.28% ] (7.0620) Net Cost of Factoring (0.0093) Effective Cost of Factoring = X 100 / = % Page - 8 of 8

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