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Q: A company makes annual credit sales of $1,500,000.Credit terms are 30days, but its debt administration has been poor and the average collection period has been 45days with 0.5% of sales resulting in bad debts which are written off.
A factor would take on the task of debt administration and credit checking, at annual fees of 2.5% credit sales .The company would save $30,000 a year in administration costs.The payment period would be 30days.
The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current base rate). The company can obtain an overdraft facility to finance its accounts receivable at a rate of 2.5 % over base rate
Should the factor’s services be accepted?Assume a constant monthly turnover.I don’t understand one part of the answer provided is :”
Extra interest cost of factor finance 30/365 x$1,200,000 x(14-13.5) %=(493)The factor is charging 14% interest.
Because this is 3% over the base rate, it means that the base rate must be 11%.
The overdraft rate is 2.5% over base rate and so is 13.5%
So….the company is paying 14% to the factor to get the money sooner, but is saving 13.5% overdraft interest as a result. So the net extra cost is the difference of 0.5%.
The question says” The factor would also provide an advance of 80%”
If using factoring,why not saving overdraft interest for 20%? $1,500,000 x 20% = $300,000
And $300,000 x 30/365 x 13.5%?
Why they calculate the overdraft interest rate based on $1,200,000 and compare?
Thank you.The factor is reducing the payment period to 30 days. So (ignoring the advance for the moment) the average receivables will be 30/365 x $1,500,000 throughout the year.
Of this amount, the factor will advance 80% immediately but they will charge 14%. If they didn’t advance it and waited the 30 days, then there would be extra overdraft interest on the amount of 13.5%.
So by have the factor advance the payment of the 80%, it is costing 80% x 30/365 x $1,500,000 x 0.5%
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