- 15 Marks
FM – L2 – Q112 – Management of receivables and payables
Question
Nsawkaw Tech Solutions Limited is a software business owned and managed by computer software specialists. Although sales have remained stable at GH¢40,000,000 per annum in recent years, the level of trade receivables has increased significantly. A recent financial report submitted to the owners indicates an average settlement period of 60 days for trade receivables compared with an industry average of 40 days. The level of bad debts has also increased in recent years, and the company now writes off approximately GH¢40,000 in bad debts each year.
The recent problems experienced in controlling credit have led to a liquidity crisis for the company. At present, the company finances its trade receivables by a bank overdraft at an interest rate of 14% a year. However, the overdraft limit has been exceeded on several occasions in recent months, and the bank is now demanding a significant decrease in the size of the overdraft.
To meet this demand, the owners of the company have approached a factor who has offered to make an advance payment equivalent to 85% of trade receivables, based on the assumption that the level of receivables will be in line with the industry average.
The factor will charge a rate of interest of 12% a year for this advance. The factor will take over the sales records of the company and, for this service, will charge a fee based on 2% of sales. The company believes that the services offered by the factor should eliminate bad debts and lead to administrative cost savings of GH¢52,000 per year.
Required
(a) Calculate the effect of employing a debt factor on the profit of Nsawkaw Tech Solutions Limited. Comment on your findings.
Note: You may assume 360 days in a year.
(b) State FIVE potential advantages and TWO disadvantages of using the services of a debt factor by a business organisation.
Answer
(i) Cost of current policy – Credit sales
Credit sales: GH¢40,000,000
Average credit period: 60 days
The annual cost is as follows:
| Description | Calculation | GH¢ |
|---|---|---|
| Cost of financing receivables | (60/360) × GH¢40,000,000 × 0.14 | 933,333 |
| Bad Debts | 0.5% × GH¢1,500,000 | 7,500 |
| Total Cost | 940,833 |
(ii) Cost of using a factor
80 percent of credit sales financed by the factor would be 85% of GH¢40,000,000 = GH¢34,000,000.
For a consistent comparison, we must assume that 15% of credit sales would be financed by a bank overdraft.
The average period would be only 40 days (industry average).
In view of the above, the annual cost of using a factor would be as follows:
| Description | Calculation | GH¢ |
|---|---|---|
| Factor’s finance charges | (40/360) × (0.85 × GH¢40m) × 0.12 | 453,333 |
| Bank overdraft (interest) | (40/360) × (0.15 × GH¢40m) × 0.14 | 140,000 |
| Factor’s service charge | 0.02 × GH¢40m | 800,000 |
| Less: Savings in Company’s administration cost | (52,000) | |
| Cost of using a factor | 1,341,333 |
Comment:
Factoring is more expensive in this case because of the 2 percent charge on sales, which is GH¢800,000. This appears too high. However, since the service charge cannot be eliminated or reduced (in this case), the resulting difference of GH¢400,500 (GH¢1,341,333 – GH¢940,833) makes factoring of the company’s debt unattractive; hence, it is not advisable for Nsawkaw Tech Solutions Limited to engage the services of a factor.
(b) (i) Potential advantages of using the services of a debt factor include the following:
- Savings in the cost of credit administration.
- Releasing key staff engaged in debt recovery exercise for other tasks.
- Greater certainty in cash inflow.
- Receiving advice on the creditworthiness of customers.
- In the case of full-service non-recourse factoring, the company will be provided with full or partial protection against bad debts.
- The fear customers have for factors may prompt the debtors to pay up.
- Receiving information on market trends, competitors, and customers.
(ii) Potential disadvantages of using the services of a debt factor include the following:
- It is an indication that the business is experiencing financial difficulties, which may have an adverse effect on the confidence of customers, suppliers, and staff.
- It may increase the operating cost of the company.
- In the case of full-service recourse factoring, the company is not protected against the risk of bad debts.
- Tags: Advantages, Business Operations, Credit Control, Debt Management, Disadvantages, Factoring
- Level: Level 2
- Uploader: Samuel Duah