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A company is considering factoring its receiveables and expects the average time taken for customers to pay to fall from 75 to 45 days. Administration savings are expected to be $100,000. Credit sales are $16 mil per annum and the company has a cost of capital of 8%.
What is the financial effect of this proposal?
A increase in profit of $105,205
B increase in profit of $205,205
C increase in profit of $157, 808
D increase in profit of $257, 808Average payable days will fall from 75 to 45 days, so a fall of 75 – 45 = 30 days.
Average receivables balance will therefore fall by credit sales $16m * 30/365 = $1,315,068
Company will therefore need $1,315,068 less in working capital, and the saving will be at the cost of capital so $1,315,068 * 8% = $105,205
Add that to the $100k administration saving and you get an increase in profit of $205,205
This receivables management topic is a bit of a challenge to me: I am not sure if my question would make much sense but why is it 8% of 1315068 the saving in cost of capital and not the 16 mil – 1315068 * 8%?
$16m is the annual credit sales for the year. If those sales are evenly spread out through the year, and customers take 75 days on average to pay, that means at any given time, the receivables balance is 75/365 * 16m = $3,287,671
If the receivables days drops to 45, then customers are paying in 45 days on average. That means the average receivables balance is 45/365 * 16m = $1,972,603
While they are waiting for the customers to pay, that’s cash that the company doesn’t have in their account. So they need extra working capital to cover this amount, which costs them – either through extra borrowing costs, or through not earning interest that they otherwise would. The rate of this cost is represented by the cost of capital.
If the receivables days reduces, the company is getting paid quicker and so they need to hold less working capital. Therefore, the saving to the company when the receivables days reduces, is the reduction in the average receivables balance multiplied by the cost of capital.
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