Question 6.SE.5: Cybele Technology Ltd is a software business that is owned a...
Cybele Technology Ltd is a software business that is owned and managed by two computer software specialists. Although sales have remained stable at £4 million per year in recent years, the level of trade receivables has increased significantly. A recent financial report submitted to the owners indicates an average settlement period for trade receivables of 60 days compared with an industry average of 40 days. The level of bad debts has also increased in recent years and the business now writes off approximately £20,000 of bad debts each year.
The recent problems experienced in controlling credit have led to a liquidity crisis for the business. At present, the business finances its trade receivables by a bank overdraft bearing an interest rate of 14 per cent a year. However, the overdraft limit has been exceeded on several occasions in recent months and the bank is now demanding a significant decrease in the size of the overdraft. To comply with this demand, the owners of the business have approached a factor who has offered to make an advance equivalent to 85 per cent of trade receivables, based on the assumption that the level of receivables will be in line with the industry average. The fac-tor will chargea rate of interest of 12 per cent a year for this advance. The factor will take over the sales records of the business and, for this service, will charge a fee based on 2 per cent of sales. The business believes that the services offered by the factor should eliminate bad debts and should lead to administrative cost savings of £26,000 per year.
Required:
(a) Calculate the effect on the profit of Cybele Technology Ltd of employing a debt factor. Discuss your findings.
(b) Discuss the potential advantages and disadvantages for a business that employs the ser-vices of a debt factor.
Cybele Technology Ltd
(a) Cost of current policies
| £ | |
| Cost of financing receivables (60/365 × £4m × 14%) | 92,055 |
| Bad debts | \underline{20,000} |
| \underline{112,055} | |
| Cost of using a factor | |
| Factor service charge (2% × £4m) | 80,000 |
| Finance charges (40/365 × (85% × £4m) × 12%) | 44,712 |
| Bank overdraft charges (40/365 × (15% × £4m) × 14%) | \underline{9,205} |
| 133,917 | |
| Less Administration cost savings | \underline{(26,000 )} |
| \underline{107,917} |
The expected increase in profits arising from using a factor is:
£112,055 − £107,917 = \underline{£4,138}
Thus it would be more profitable to employ a factor. However, the difference between the two options is fairly small and other considerations, such as the need for the busi-ness to control all aspects of customer relationships, may have a decisive influence on the final outcome.
(b) This topic is dealt with in the chapter. The main benefits include savings in credit man-agement, releasing key individuals for other tasks, cash advances linked to sales activity and greater certainty in cash flows.