Evaluation framework of factoring – Illustration

The Reliable Industries Ltd (RIL) is presently managing its account receivables internally by the sales and credit department. Its credit terms for sales are 2 / 10 net. 30. The past experience of RIL has been that on an average 30 per cent of the customers avail of the discount, while the balance of the receivables is collected on an average 60 days after the invoice date. Further, 2 per cent of the sales turnover results in bad debts.

The firm is financing its investments in receivables through a mix of bank finance and long term finance in the ratio of 2:1. The effective rate of interest on bank finance is 22 per cent and the cost of own funds is 30 per cent.

The projected sales for the next year is Rs 500 lakh. The credit and collection department spends on an average one fourth of its time on collection of receivables.

A proposal to avail of factoring service from Fair growth Factors Ltd (FFL) as an alternative to in-house management of receivables collection and credit monitoring is under the consideration of the Board of Directors of the RIL. If the proposal details of which are given as follows, is accepted, it is expected that the projected sales for the next year can increase by Rs 50 lakh as a result of the diversion of the time of the executives of the sales, credits and collection department to sales promotion. For the type of product that RIL is producing, the gross margin on sales in the past has been 20 per cent. Moreover, there would be a saving in administrative overheads amounting to Rs 2.5 lakh due to discontinuance of sales ledger administration and credit monitoring.

According to the factoring proposal, the FFL offers a guaranteed payment of 30 days. The other details are listed as follows:

The FFL would advance 80 percent and 85 percent in case of recourse and non-recourse factoring deals respectively, the balance would be retained as factor reserve. The discount charge in advance (up-front) would be 22 per cent for recourse type and 21 percent for non-recourse type of service. The FFL would also charge a commission @ 2 percent (recourse) and 4 per cent non-recourse. The commission is payable up-front.

Before taking a decision on the proposal, the Board seeks your advice, as a financial consultant on the course of action. What advice would you give? Why?


Decision Analysis: In House Management Alternative

Relevant costs Amount (Rs lakh)

Cash discount 3.00(Rs 500 x 0.02 x 0.03)
Cost of funds in receivables 15.42 (Working note 1)
Bad debt losses 10.00 (Rs 500 x 0.02)
Lost contribution on foregone sales 10.00 (Rs 50 x 0.20)
Avoidable administrative overheads 2.500
Total 40.92

Working Notes:

Cost of funds invested in receivables :
Average collection period= (10 days x 0.03) + ( 60 days x 0.07) = 45 days
Cost of bank finance = Rs 500 lakh x 2 / 3 x 45 / 360 x 0.22 = Rs 9.16 lakh
Cost of own funds = Rs 500 lakh x 1 / 3 x 45 / 360 x 0.03 = Rs 6.25 lakh.
Total = Rs 15.42 lakh.

Decision Analysis Factoring Alternative

Relevant costs Amount (Rs lakh)

Factoring commission 11.00 (Rs 550 x 0.02)
Discount charge 7.90 (Working note 2)
Cost of long term funds 2.97( Rs 550 – Rs 431.2)x 0.03 x 30 / 360)
invested in receivables
Total 21.87

Working Notes:

Eligible amount of advance = 0.80 x (Rs 550 – Rs 11) = Rs 431.2 lakh
Discount charge= Rs 431.2 x 0.22 x 30 / 360 = Rs 7.90 lakh.

Decision Analysis: Non recourse Factoring Alternative:

Relevant costs Amount (Rs lakh)

Factoring commission 22.00 (Rs 550 x 0.04)
Discount charge 7.85 (Working note 3)
Cost of long term funds 2.53(Rs550–Rs448.8)x0.03×30/ 360
Invested in receivables

Total 32.38

Working Notes:

Eligible amount of advance = 0.85 x (Rs 550 – Rs 22) = Rs 448.8 lakh
Discount charge = Rs 448.8 x 0.21 x 30 /360 = Rs 7.85 lakh.

Decision Analysis: Cist Benefit of Recourse Factoring (Rs lakh)

Benefits = Rs 3.00 + Rs 15.42 + Rs 10.00 + Rs 2.50 = Rs 30.92

Costs = Rs 11.00 + Rs 7.90 + Rs 2.97 = Rs 21.87

Net Benefit = Rs 9.05

Decision Analysis: Cost Benefit of Non-recourse Factoring (Rs lakh)

Benefit = Rs 3.00 + Rs 15.42 + Rs 10.00 + Rs 10.00 + Rs 2.50 = Rs 40.92
Cost = 22.00 + Rs 7.85 + Rs 2.53

Net Benefit = Rs 8.54

As a financial consultant, my advice to the Board of RIL would be to choose recourse factoring due to higher net benefits.