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The CFO of a company is concerned about the company’s accounts receivable turnover ratio. The company currently offers customers terms of 3% discount for settlement within 10 days or full payment within 30 days.
Which of the following strategies is most likely to improve the company’s accounts receivable turnover ratio?
A. Using invoice discounting
B. Changing customer terms to a 1% discount for settlement within 10 days
C. Entering into a factoring agreement with a finance company
D. Changing customer terms to a 3% discount for settlement within 20 daysThe correct answer is C. (By ACCA Hap)
Tutorial note: The accounts receivable turnover ratio is expressed as Sales/Accounts Receivable. A reduction in accounts receivable would serve to improve (increase) the turnover ratio. Factoring would probably reduce the receivables collection period, and hence the level of receivables, thereby increasing (improving) the company’s accounts receivable turnover ratio.
I understand why invoice discounting (Option A) is not ideal, as it doesn’t reduce the receivable balance on the financial statement. I also see how offering a longer discount period (Option D) may have less impact on receivables. However, I’m unclear on why factoring is considered the best option, since its effectiveness depends on the expertise and efficiency of the factor.
Factoring is considered the best option for improving the accounts receivable turnover ratio because it typically leads to a reduction in the receivables collection period.
When a company enters into a factoring agreement, it sells its receivables to a finance company, which then takes over the responsibility of collecting payments from customers. This can result in faster cash inflows and a decrease in the average accounts receivable balance on the financial statements.
By reducing the level of receivables, the accounts receivable turnover ratio, calculated as Sales divided by Accounts Receivable, will increase.
Whilst I agree with your comment, the effectiveness of factoring often lies in the factor’s expertise in managing collections, which then can lead to improved cash flow and reduced administrative burdens for the company.
But the primary benefit is the immediate impact on the receivables balance and the associated turnover ratio.
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