Question 18.3: Cost of Factoring For the year just ended, LuLu’s Pies had...
Cost of Factoring
For the year just ended, LuLu’s Pies had an average of $50,000 in accounts receivable. Credit sales were $50,000 .LuLu’s factors its receivables by discounting them 3 percent—in other words, by selling them for 97 cents on the dollar. What is the effective interest rate on this source of short-term financing?
To determine the interest rate, we first have to know the accounts receivable, or average collection, period. During the year, LuLu’s turned over its receivables $500,000/50,000 = 10 times. The average collection period is therefore 365/10 = 36.5 days.
The interest paid here is a form of discount interest (discussed in Chapter 6 ). In this case, LuLu’s is paying 3 cents in interest on every 97 cents of financing. The interest rate per 36.5 days is thus .03/.97 = 3.09%. The APR is 10×3.09% = 30.9%, but the effective annual rate is:
EAR=1.0309^{10}-1=35.6\%
Factoring is a relatively expensive source of money in this case. We should note that, if the factor takes on the risk of default by a buyer, then the factor is providing insurance as well as immediate cash. More generally, the factor essentially takes over the firm’s credit operations. This can result in a signifi cant saving. The interest rate we calculated is therefore overstated, particularly if default is a signifi cant possibility.