A firm has total annual sales of ₹200 lakhs, of which 80% are made on credit. The company offers credit terms of 2/40, net 120. Out of the total…

CA Intermediate · Financial Management and Strategic Management · RTP · September 2026
A firm has total annual sales of ₹200 lakhs, of which 80% are made on credit. The company offers credit terms of 2/40, net 120. Out of the total credit customers, 50% avail themselves of the cash discount, while the remaining customers settle their accounts after 120 days. Based on past experience, bad debt losses amount to approximately 1% of credit sales. In addition, the firm incurs ₹2,40,000 per annum in administering its credit sales. These costs can be avoided because a factor is willing to purchase the firm's receivables. The factor will charge a 2% commission and provide advances against receivables at an interest rate of 18%, while retaining 10% of the receivables as a reserve. Required: (i) Determine the effective cost of factoring. Assume a 360-day year. (ii) If bank finance for working capital is available at an interest rate of 14%, advise whether the firm should avail itself of the factoring service.

Suggested Answer and Working Notes:

Particulars (₹) Total Sales ₹200 lakhs Credit Sales (80%) ₹160 lakhs Receivables for 40 days (50% of credit sales) ₹80 lakhs Receivables for 120 days (50% of credit sales) ₹80 lakhs Average collection period [(40 x 0.5) + (120 ×0.5)] 80 days Average level of Receivables (₹1,60,00,000 × 80/360) ₹35,55,556 Factoring Commission (₹35,55,556 × 2/100) ₹71,111 Factoring Reserve (₹35,55,556 × 10/100) ₹3,55,556 Amount available for advance {₹35,55,556 - (3,55,556 + 71,111)} ₹31,28,889 Factor will deduct his interest @ 18% : Interest = (₹31,28,889 × 18 × 80) / (100 × 360) ₹1,25,156 Advance to be paid (₹31,28,889 – ₹1,25,156) ₹30,03,733 (i) Statement Showing Evaluation of Factoring Proposal ₹ A. Annual Cost of Factoring to the Firm: Factoring commission (₹71,111 × 360/80) 3,20,000 Interest charges (₹1,25,156 × 360/80) 5,63,200 Total 8,83,200 B. Firm's Savings on taking Factoring Service: ₹ Cost of credit administration saved 2,40,000 Bad Debts (₹160,00,000 × 1/100) avoided 1,60,000 Total 4,00,000 C. Net Cost to the firm (A – B) (₹8,83,200 - ₹4,00,000) 4,83,200 Effective cost of factoring = (₹4,83,200 / ₹30,03,733) × 100 = 16.09% * If cost of factoring is calculated on the basis of total amount available for advance, then, it will be (₹4,83,200 / ₹31,28,889) × 100 = 15.44% (ii) If Bank finance for working capital is available at 14%, firm will not avail factoring service as 14% is less than 16.08% (or 15.44%)

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

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