Receivables Financing and the Supplier Discount
Ridgeline Outdoor Supply has annual credit sales of $1.2 million and an average collection period of 55 days, leaving about $181,000 in accounts receivable. Cash on hand is $28,000. A local bank offers a line of credit at 8.5% annual interest, secured by receivables, with $150,000 available. A factor offers to purchase receivables without recourse: an 85% advance, a 2% factoring fee on the face amount, and 1% monthly interest on the advance. Ridgeline's main supplier offers terms of 2/10, net 45. The owner wants to know whether to use the factor to pay suppliers early, use the bank line, or forgo the discount.
1. Calculate the annualized cost of forgoing the 2/10, net 45 discount. Should Ridgeline borrow on the bank line to take the discount? Show the comparison on a $10,000 invoice.
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Forgoing the discount means paying $10,000 at day 45 instead of $9,800 at day 10. The $200 saving is given up for 35 extra days on $9,800.
Cost = ($200 / $9,800) x (365 / 35) = 2.0408% x 10.4286 = about 21.3% annualized.
Bank line interest on $9,800 for 35 days = $9,800 x 0.085 x 35 / 365 = about $79.89. Net benefit of borrowing and taking the discount = $200 - $79.89 = about $120.11 per $10,000 invoice, before fees.
The discount is worth taking if the line has capacity and the invoice is legitimate. The company should prioritize invoices with the largest discount and avoid drawing the line for invoices that will not be paid within terms.
2. Estimate the explicit cost of factoring one 55-day receivables cycle of $181,000 and compare it with the bank line. What risk does factoring transfer?
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Factoring fee = 2% x $181,000 = $3,620. Advance = 85% x $181,000 = $153,850. Interest at 1% per month for 55 days, or about 1.83 months, is $153,850 x 0.01 x 1.83 = about $2,816. Total explicit cost is about $6,436.
As a percent of the advance, $6,436 / $153,850 = 4.18% per 55-day cycle, or about 27.7% annualized. Bank line interest for 55 days on $181,000 at 8.5% = $181,000 x 0.085 x 55 / 365 = about $2,318. Factoring costs roughly 2.8 times the bank line in explicit terms.
Because the arrangement is without recourse, the factor bears customer credit risk and collection work. That can be valuable if the bank line is full or collections are the bottleneck, but the price is high relative to the secured line.
3. What should Ridgeline do, and under what conditions would factoring become the better choice?
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Ridgeline should not forgo the supplier discount. It should first use the bank line to pay invoices within the discount period, prioritizing invoices where the 21.3% annualized discount return clearly exceeds the 8.5% line cost. It should also forecast cash closely because the $150,000 line is smaller than the $181,000 receivables balance and may not cover all payables at once.
Factoring becomes more defensible if the bank line is fully used, if slow-paying customers are creating a collection capacity problem, if the company cannot absorb bad-debt risk, or if the factor will fund a growth opportunity that the bank will not. Before signing, the owner should compare the all-in factor cost, reserve terms, minimum volume, customer notification rules, and contract termination fees. Factoring should not be used merely to pay suppliers early when cheaper secured credit is available.