Cybele Technology Ltd. is a software business owned and managed by two computer software specialists. Although sales have remained stable at $4 million per year in recent years, the level of receivables has increased significantly. A recent financial report submitted to the owners indicates an average collection period for 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 receivables by a bank overdraft bearing an interest rate of 14% 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% of receivables, based on the assumption that the level of receivables will be in line with the industry average. The factor will charge a rate of interest of 12% a year for this advance. The factor will take over the sales ledger of the business and, for this service, will charge a fee based on 2% 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 net income of Cybele Technology Ltd. of employing a receivables factor. Discuss your findings.
(b) Discuss the potential advantages and disadvantages for a business that employs the services of a receivables factor.