Factoring versus overdraft at Meridian Packaging
Meridian Packaging Ltd sells corrugated cartons on credit and expects credit sales of ₹18 crore next year. Its current collection period is 75 days, bad debts run at 1.5% of sales, and internal credit administration costs ₹10 lakh a year. The firm finances 75% of receivables through a bank overdraft at 14% p.a.; the remaining receivables are funded by owners’ funds. A factor has offered a non-recourse arrangement: 80% advance against receivables at 12% p.a., a 2% commission on all sales factored, and a 20% reserve released on collection. The factor’s follow-up is expected to cut the collection period to 45 days, with sales and the bad-debt rate unchanged. The finance manager is also worried that the factor will demand a 3% commission after year one. The CFO wants a decision that considers both the annual cost and the operational risk of losing direct customer contact.
1. Compute the annual financial impact of accepting the factoring arrangement at a 2% commission, comparing it with the existing overdraft-and-in-house-collection arrangement. State clearly any assumptions.
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Assumptions: 365-day year; all credit sales are factored; the overdraft finances only receivables; the 20% reserve earns no interest; the opportunity cost of funds locked in the reserve is 14%.
Existing arrangement
- Receivables = ₹18 crore × 75/365 = ₹3.699 crore.
- Overdraft = 75% × ₹3.699 crore = ₹2.774 crore.
- Interest = 14% × ₹2.774 crore = ₹0.388 crore.
- Bad debts = 1.5% × ₹18 crore = ₹0.270 crore.
- Administration = ₹0.100 crore.
- Total annual cost = ₹0.758 crore.
Factoring at 2%
- Receivables = ₹18 crore × 45/365 = ₹2.219 crore.
- Advance = 80% × ₹2.219 crore = ₹1.775 crore.
- Interest on advance = 12% × ₹1.775 crore = ₹0.213 crore.
- Commission = 2% × ₹18 crore = ₹0.360 crore.
- Reserve = 20% × ₹2.219 crore = ₹0.444 crore; opportunity cost at 14% = ₹0.062 crore.
- Total factoring cost = ₹0.360 + ₹0.213 + ₹0.062 = ₹0.635 crore.
The direct cost saving is ₹0.758 − ₹0.635 = ₹0.123 crore. In addition, owners’ funds tied up fall from 25% × ₹3.699 crore = ₹0.925 crore to the ₹0.444 crore reserve, releasing ₹0.481 crore. At 14%, that release is worth about ₹0.067 crore, giving a total economic gain of about ₹0.190 crore. The break-even commission on the direct-cost basis is about ₹0.483 crore, or 2.68% of sales. At 3%, the direct cost rises to about ₹0.815 crore, which is marginally worse than ₹0.758 crore before the release benefit; after the release benefit, the net gain is only about ₹0.010 crore.
2. Advise whether Meridian should accept the factor at 2% and how it should handle the year-two commission risk. Include two non-financial factors.
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Accept the 2% arrangement, but as a controlled contract rather than an open-ended outsourcing decision. The direct saving is about ₹12.3 lakh and the total economic gain about ₹19 lakh, which is material against an EBITDA that is not stated but is likely thin in packaging. The factor also transfers bad-debt risk and removes the need to chase overdue accounts.
The year-two risk is real: at 3%, the direct-cost advantage almost disappears and the decision becomes sensitive to service quality and reserve-release assumptions. Meridian should negotiate a 24-month commission cap at 2%, a six-month trial with an SLA on collection period and cash application, and a review trigger if DSO exceeds 50 days. It should retain ownership of customer data and key-account relationships, and require the factor to follow Meridian’s escalation script for strategic accounts.
Two non-financial factors are: (1) loss of direct customer contact can weaken cross-selling and early warning of customer distress; (2) operational dependence on a single factor creates transition risk if service levels fall or the contract is repriced. Mitigate by keeping a small in-house credit team for top accounts and a fallback overdraft limit. Do not accept 3% without a fresh comparison; at that level the case is marginal and should be rejected unless the factor demonstrably improves collection and bad-debt recovery.