discount period at an annual interest rate of 12% and saves $26.93, computed as follows:
| Discount of 2% on $2,000 | $40.00 |
| Interest for 20 days, at a rate of 12% on $1,960 ($2,000 - $40) | $13.07 |
| Savings effect by borrowing | $26.93 |
How is it used and applied?
Computing the cost of credit is an essential part of doing business. You should always be weighing the savings gained by paying early against the benefit of holding onto your money longer. Which is more advantageous to you: paying a smaller amount sooner, or paying more later by having the use of the funds in the meantime? The only way to answer those questions is to work through the numbers both ways, and compare the results.
If you do not take the discount, you are losing the savings; the amount lost is the true cost of the credit. However, that cost may be of secondary importance to you if other forms of finance are not available. On the other hand, if bank credit is not a problem, you may be better to forgo the discount and invest the money short term in something that generates revenue.
Doing this now/later analysis is a continual process. Your decisions may change from one month to the next, as your cash flow changes. You should also be aware that the amounts of discount offered to you will often change to reflect the overall economic climate. Thus the cost of not taking trade credit usually declines as discount terms are reduced. Also, you may be available to negotiate with your major suppliers for a more favorable discount, especially if you have a strong record with them or they are particularly eager for cash.
7. Receivables and Inventory Financing
Introduction
You may be able to improve your business’ cash flow by using receivables or inventory as collateral for loans. Both these assets represent important financing sources because they are significant in amount and relate to recurring business activities.
1Receivable Financing
Receivable financing is the use of short-term financing backed by financing backed by receivables, under either a factoring or an assignment arrangement. The financing of accounts receivable is facilitated if customers are financially strong, sales returns are minimal, and title to the goods is received by the buyer at shipment.
Factoring of Accounts Receivable
Factoring is the outright sale of accounts receivable to a third party without recourse; the purchaser assumes all credit and collection risks. The factor will usually advance you up to 80 percent, meaning that the factor buys the receivables for 80 percent of face value. The factor collects the full amount from the customer and keeps the difference. The proceeds you receive equal face value minus commission, fee and discount. The amount the factor will advance depends on the quality of the accounts receivable. The cost of factoring includes the factor’s commission for credit investigation of the customer, interest charges, and the discount from the face value of the receivables. The factor’s total fee depends on the volume of business you give the factor and the credit-worthiness of your customers. Billing and collection are done by the factor.
How is it computed?
The cost of a factoring agreement is computed as follows:
Factor fee + cost of borrowing = total cost
Example 1
You have $10,000 per month in accounts receivable that a factor will buy, advancing you up to 75 percent of the receivables for an annual charge of 15 percent and a 1.0 percent fee on receivables purchased. The cost of this factoring arrangement is:
| Factor fee [0.01 × ($10,000 × 121)] | $1,200 |
| Cost of borrowing [0.15 × ($10,000 × 0.751)] | 1,125 |
| Total cost | $2,375 |
Assignment of Accounts Receivable
Assignment is the transfer of accounts receivable to a finance company with recourse: if the customer does not pay, you (as borrower) have to pay. The accounts receivable act as collateral, and new receivables substitute for receivables collected. Ownership of accounts receivable is not transferred. Customer payments continue to be made directly to you.
How is it computed?
The finance company usually advances between 50 and 85 percent of the face value of the receivables in cash. You incur a service charge and interest on the advance, and you absorb any bad debt losses. The cost is computed as follows:
Service charge + interest + bad debt = total cost
2 Inventory Financing
Inventory financing is the use of inventory as collateral for a loan. This typically occurs when you have fully exhausted your borrowing capacity on receivables.
Inventory financing requires the existence of marketable, nonperishable, standardized goods with fast turnover. Inventory should preferably be stable in price; expenses associated with its sale should be minimal.
How is it computed?
The cost of inventory financing is computed as:
Interest + warehouse cost = total cost
Example 2
You want to finance $250,000 of inventory. Funds are required for 2 months. An inventory loan may be taken out at 14 percent with an 80 percent advance against the inventory’s value. The warehousing cost is $2,000 for the 2-month period. The cost of financing the inventory is:
| Interest (0.14 × 0.80 × $250,000 × 2/12) | $4,667 |
| Warehousing cost | 2,000 |
| Total cost | $6,667 |
How is it used and applied?
The advantages of receivables financing are that it (1) avoids the need for long-term financing and (2) provides needed cash flow. Its major disadvantage is its high administrative cost if the business has many small accounts.
The advantages of factoring are that (1) you receive immediate cash, (2) overhead is reduced because credit investigation is no longer needed, (3) you can obtain advances as needed on a seasonal basis, and (4) there are no loan restrictions or required account balances. Disadvantages are that factoring involves (1) high cost, (2) possible negative customer reaction and (3) possible antagonism from customers who are past due and who are subject to pressure from the factor.
Advantages of assignment are that (1) cash is immediately available, (2) cash advances are received on a seasonal basis, and (3) it avoids negative customer reaction. Its disadvantages are (1) its high cost, (2) the continued credit function, and (3) significant credit risks.
The advance on inventory financing is usually higher for readily marketable goods. A bank will typically lend about 50 percent of the market value of merchandise at an interest rate about 3 to 50 points over the prime interest rate.
Disadvantages of inventory financing include its high interest rate and the restrictions often placed on the inventory.
8. Estimating the Cost of Debt and Equity Financing
Introduction
The business owner should observe that if she invests money today to receive benefits in the future, she must be absolutely certain that the business earns at least as much as it costs to acquire the funds for the business. This amount is called the minimum acceptable return. If funds cost the business 10 percent, the owner must be sure that she is earning at least this rate of return.
