CAT T10-Monitoring and collecting debts part 2/2

This article is continued with the last article which had discussed about monitoring and collecting debts. In this article, I will discuss two more methods of collecting debts which are factoring and invoice discounting. First let me talk about factoring.

Factoring is an arrangement to have debts collected by a factor company which advances a proportion of the money it is due to collect. Well the definition may not be clear, let me make it simplier, the organisation providing the factor service is "factor" and the company which requests for this service is "company". Factors are most of the time financial institutions and they provide factoring service to company. Factoring provides a form of advance against a company's trade receivables. Instead of the company having to wait for cash from its credit customers, the factor agrees to pay for a proportion of the debt in advance to the company. Typically a factor will pay up to 85% of approved invoices. Factor will also take the administration of sales ledger of the company which the company does not have to employ credit controllers. The main aspects of factoring are:
(i) administration of the company's invoicing, sales accounting and debt collection service
(ii) credit protection for company's debts, whereby the factor takes over the risk of loss from bad debts and so "insures" the company against such losses. The factor usually purchases these debts 'without recourse' to the company, which means that if the company's customers do not pay what they owe, the factor will not ask for his money back from the company.
(iii) Making payments to the client in advance of collecting the debts.
The steps involve in factoring would be:
1. company sells goods to the customer on credit payable in 30 days
2. company sells the debt to the factor, the factor administers the sales ledger
3. up to 85% of the debt is paid to the company in advance
4. the customer pays the factor after 30 days
5.factor pays the company the balance less administration fees and financing fees

Advantages of factoring are:
(i)The business can pay its suppliers promtly, and so be able to take advantage of any early payment discounts that are available
(ii)Optimum inventory levels can be maintained, because the business will have enough cash to pay for the inventories it needs
(iii)Growth can be financed through sales rather than by injecting fresh external capital
(iv)The business gets finance linked to its volume of sales. In contrast, overdraft limits tend to be determined by historical statements of financial position
(v)The managers of the business do not have to spend their time on the problems of slow paying customers
(vi)The business does not incur the costs of running its own receivables ledger department
An important disadvantage of factoring is that customers will be making payments direct to the factor, which is likely to present a negative picture of the company as they might think that the business may not be running well that it needs to employ factoring service.

Invoice discounting does not mean offerring discounts to customers. Invoice discounting is the purchase (by the invoice discounter) of trade debts at a discount. Invoice discounting is related to factoring and many factors will provide an invoice discounting service. It is entirely different thing from the provision of early settlement discounts. It is almost the same as factoring, but the invoice discounter does not take over the administration of the company's receivables ledger, the arrangement is purely for the advance of cash. But the main advantage compare with factoring is that customer does not know that the company is using invoice discounting service, customer is still paying back to the company. Therefore it enables the company to raise working capital. But the disadvantage is the company will still need to have a receivable ledger or credit control department for collecting the debts, these collections will be given back to invoice discounter.

Both methods of collecting debts are useful especially when the company is in short of money. We also need to consider whether the company is financially viable to factor its debts or not before employing the service. You need to check the cost of factoring and also the cost of not factoring, if the cost of factoring is lower, then the company might prefer to factor its debts. Normally when the company does not factor the debts, the cost that will be incurred will include the salary for credit control staff, sales ledger administration cost and also overdraft interest charge. If the company chooses to factor the debts, the cost that will be incurred might be the redundancy package for making the credit control staff redundant (as the company does not need much credit control staff), factor administration fees, factor's interest charge on the advance pay to company, overdraft interest charge for financing the rest of the debtors balance and also credit protection charge for "without recourse" agreement. I think one example might be useful to understand more.

Eg. Mr Sykes expects sales for next year to be $75000, with customers paying within 30-day limit set. It would cost him $2000 per annum to employ someone one day a week to invoice customers and collect debts for him. Alternatively, his local bank has offered to provide a factoring service for him, including the advance of 80% of his sales invoices. They would charge 2% of turnover for the administration and charge interest of 8% per annum on advances. However, the bank would not invoice Mr Sykes' customers. He would need to employ somebody for half a day a week to do this, at a cost of $1000 per annum. My Sykes pays interest at the rate of $10% per annum on his overdrawn bank account. Mr Sykes thinks that customers will pay within 30 days regardless of which option is selected.
Calculate and recommend whether or not Mr Sykes should factor his debts.
Answer: Average receivables=30/365 x $75000=$6164
Cost of not factoring:
-$6164 x 10% financed by overdraft=$616
-Administration cost=$2000
=$2616
Cost of factoring:
-80% advanced by factor at 8% (80% x $6164 x 8%)=$394
-20% still financed by overdraft (20% x $6164 x 10%)=$123
-Factor administration charge (2% x $75000)=$1500
-Invoicer cost = $1000
=$3017
Mr Sykes should not factor his debts because the cost of factoring is more than the cost of not factoring.

I had discussed assessing creditworthiness and monitoring and collecting debts, in next article I will discuss managing receivables which is the main thing in working capital management and the articles that I discussed before is part of the managing receivables. I hope this article is clear enough to understand.