Halden Components: settlement discount versus factoring
Halden Components Ltd has revenue of $24.0m and cost of sales of $18.0m. Its statement of financial position shows receivables of $5.0m, inventory of $3.2m and payables of $2.8m. The overdraft rate is 9% a year and the company is close to its agreed limit. A key supplier has offered a 2% settlement discount for payment within 10 days rather than the current 60 days, which matches Halden's payables period. Separately, a factor has offered to buy the receivables book: 80% of invoices advanced immediately at 7% a year, a 2% service fee on credit sales, and the factor would take over credit control. Halden currently spends $180,000 a year on credit control, which the proposal would eliminate.
1. Calculate Halden's cash operating cycle and evaluate whether the 2% settlement discount should be accepted.
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Operating cycle
- Receivables days = 5.0/24.0 x 365 = 76.0 days
- Inventory days = 3.2/18.0 x 365 = 64.9 days
- Payables days = 2.8/18.0 x 365 = 56.8 days
- Cash operating cycle = 76.0 + 64.9 - 56.8 = 84.1 days
Cost of the discount Paying 50 days early earns 2%. The annualised cost of not taking it is 2/98 x 365/50 = 14.9%, against an overdraft cost of 9%. On a pure comparison, the discount is cheap finance.
Cash effect
- Discount earned = 2% x $18.0m = $360,000 a year
- Payables fall from 56.8 to 10 days, a reduction of 46.8 days = 18.0m x 46.8/365 = $2.307m of extra funding needed
- Interest at 9% = $207,600
- Net annual benefit = 360,000 - 207,600 = $152,400
Judgement Accept, but only after the overdraft limit is extended: the company is already close to its limit and this decision needs roughly $2.3m of headroom, otherwise the benefit is not realisable. Confirm that 2% applies to the whole $18.0m of purchases (not one product line) and that paying in 10 days is operationally achievable, since late payment forfeits the discount and may damage supply continuity. If the full $2.3m cannot be financed, take the discount on the largest invoice tranches first, where the 14.9% saving exceeds the 9% cost.
2. Assess the factoring proposal financially and recommend whether Halden should proceed.
Read the worked answer
Annual cost and benefits
- Service fee = 2% x $24.0m = $480,000
- Advance = 80% x $5.0m = $4.0m; factor's charge at 7% = $280,000
- Overdraft interest saved on that $4.0m at 9% = $360,000, a net financing gain of $80,000
- Credit control saving = $180,000
- Net cost before any change in collection speed = 480,000 - 80,000 - 180,000 = $220,000 a year
What would have to change Each 10 days taken off receivables days releases 24.0m x 10/365 = $0.658m of cash, saving $59,200 a year at 9%. To recover $220,000 the factor would need to cut receivables days by roughly 37 days, from 76 to about 39. That is plausible for a specialist collection operation, but it is an assumption, not a promise in the quote. Note also that if the book shrinks, the 80% advance and the $80,000 financing gain shrink with it, so the two effects partly overlap and the true net cost lies between $7,000 and $220,000.
Recommendation Reject the proposal as drafted. It is only marginally attractive at best, and it transfers control of customer relationships and credit limits to a third party whose interests may conflict with Halden's sales strategy. A better sequence is: first tighten internal credit control and invoice the supplier discount, then re-tender the factoring mandate with a collections target and a smaller fee written into the contract.