Raphael Ltd is a small engineering business which has annual credit sales of £2.4 million. In recent years, the company has experienced credit control problems. The average collection period for sales has risen to 50 days even though the stated policy of the business is for payment to be made within 30 days. In addition, 1.5 per cent of sales are written off as bad debts each year.
The company has recently been in talks with a factor who is prepared to make an advance to the company equivalent to 80 per cent of debtors, based on the assumption that customers will, in future, adhere to a 30-day payment period. The interest rate for the advance will be 11 per cent per annum. The trade debtors are currently financed through a bank overdraft which has an interest rate of 12 per cent per annum. The factor will take over credit control procedures of the business and this will result in a saving to the business of £18,000 per annum. However, the factor will make a charge of 2 per cent of sales for this service. The use of the factoring service is expected to eliminate the bad debts incurred by the business.
Raphael Ltd is also considering a change in policy towards payment of its suppliers. The company is given credit terms which allow a 2.5 per cent discount providing the amount due is paid within 15 days. However, Raphael Ltd has not taken advantage of the discount opportunity to date and has, instead, taken a 50-day payment period even though suppliers require payment within 40 days. The company is now considering the payment of suppliers on the fifteenth day of the credit period in order to take advantage of the discount opportunity.
Required
(a) Calculate the net cost of the factor agreement to the company and state whether or not the company should take advantage of the opportunity to factor its trade debts.
(b) Explain the ways in which factoring differs from invoice discounting.
(c) Calculate the approximate annual percentage cost of forgoing trade discounts to suppliers and state what additional financial information the company would need in order to decide whether or not it should change its policy in favour of taking the discounts offered.
(d) Discuss any other factors which may be important when deciding whether or not it should change its policy in favour of taking the discounts offered.