Sukrut Limited has annual credit sales of 75,00,000/-. Actual credit terms are 30 days, but its management of receivables has been poor, and the…

CA Intermediate · Financial Management and Strategic Management · MTP · September 2024
Sukrut Limited has annual credit sales of 75,00,000/-. Actual credit terms are 30 days, but its management of receivables has been poor, and the average collection period is about 60 days. Bad debt is 1 per cent of total sales. A factor has offered to take over the task of debt administration and credit checking, at an annual fee of 1.5 per cent of credit sales. Sukrut Limited estimates that it would save - 45,000 per year in administration costs as a result. Due to the efficiency of the factor, the average collection period would come back to the original credit offered of 30 days and bad debts would come to 0.5% on recourse basis. The factor would pay net advance of 80 percent to the company at an annual interest rate of 12 per cent after withholding a reserve of 10%. Sukrut Limited is currently financing its receivables from an overdraft costing 10 per cent per year and will continue to finance the balance fund needed (which is not financed by factor) through the overdraft facility If occurrence of credit sales is throughout the year, COMPUTE whether the factor's services should be accepted or rejected. Assume 360 days in a year.

Suggested Answer and Working Notes:

Evaluation of Factoring Proposal - PARTICULARS Particulars ₹ (A) Savings (Benefit) to the firm Administration Cost 45,000 45,000 Bad Debts Cost (On Recourse basis) In House - 75 lakhs X 1% Factoring – 75 lakhs X 0.5% (75 lakhs X 0.5%) 37,500 Net Savings in bad debts cost Cost of Carrying Debtors Cost (WN – 1) 1,06,750 TOTAL 1,89,250 (B) Cost to the Firm: Factor Commission [Annual credit Sales × % of Commission] 75 lakhs X 1.5% 1,12,500 Interest Cost on Net advances (See WN – 1) 53,100 TOTAL 1,65,600 (C) Net Benefits to the Firm (A – B) 23,650 Advice: Since the savings to the firm exceed the cost due to factoring, the proposal is acceptable. WN-1: Calculation of Savings in Interest Cost of Carrying Debtors (I) In house Management: Interest Cost = Credit Sales X Avg Collection Period / 360 X Interest (%) p.a = 75,00,000 x 60/360 x 10% = 1,25,000 (II) If Factoring services availed: If factoring services are availed, then Sukrut Limited must raise the funds blocked in receivables to the extent which is not funded by the factor (i.e amount of factor reserve (+) amount of factor commission for 30 days (+) 20% of net advances) Calculation of Net Advances to the firm - Debtors = 75 lakhs x 30/360 = 6,25,000 (-) Factor Reserve = 10% of above = (62,500) (-) Factor Commission = 1.5% of Debtors = (9,375) Net Advance = 5,53,125 Advance from Factor = 5,53,125 x 80% = 4,42,500 Int cost on Advance from Factor = 4,42,500 x 12% = 53,100 Now, the amount that is not funded by the factor (6,25,000 – 4,42,500) needs to be funded by Sukrut Limited from overdraft facility at 10% Therefore, Int cost on Overdraft (Cost of carrying debtors) = 1,82,500 x 10% = 18,250 Net Savings in Interest Cost of Carrying Debtors = 1,25,000 (-) 18,250 = 1,06,750

Topics: Part-A: Financial Management, Part B: Strategic Management

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