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Transcript of 7_Working Capital Mgmt
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Working Capital Management
1
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Overview of Working Capital Management
2
After Plant & Machinery has been installed and the manufacturing
facility is put in place, the firm would require investment made in
Short-term assets.
Firms may be required to sell finished products/services on credit
leading to Receivables (orDebtors), or maintain stocks of raw
material/finished goods leading to Inventories.
Investments in such short-term assets is called Working Capital.
Working Capital Management: An Overview
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Overview of Working Capital Management
3
Two Concepts of Working Capital: Gross Working Capital is the aggregate investment in
Current Assets. Focuses attention on (a) Trade-off between excessive and inadequate
Current Assets; (b) Financing of Current Assets.
Net Working Capital is the difference between the CurrentAssets and Current Liabilities of a firm.
Indicates the liquidity position of a firm and the suggests the extent to
which working capital requirements may be financed by long-term
sources.
Current Assets should be sufficiently in excess of the current liabilitiesand form a buffer for maturing obligations within a operating cycle.
Negative NWC means CL > CA, may prove harmful to the firm.
Working Capital Management: An Overview
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Overview of Working Capital Management
4
Current Assets: Those assets that are either in the form of cashor are expected to be converted into cash in the short term
(usually defined as less than one year).
Inventories (R/M, WIP, FG),
Debtors,
Short Term Investments,
Cash.
Current Liabilities: Those liabilities that are expected to be paid
within a year.
Creditors,
Accrued expenses,
current portion of long-term liabilities.
Working Capital Management
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Overview of Working Capital Management
5
Sales do not convert into Cash instantaneously as there is anOPERATING CYCLE Duration of time required to convert sales,
after conversion of Raw Material into Finished Goods, into Cash.
Cash
Raw
Material
Work-in-
Progress
Finished
Goods
Debtors
Purchase
Convert
Convert
Sale of
Goods
Realise
OPERATING CYCLE
Why Working Capital is required?
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Overview of Working Capital Management
6
As Operating Cycle is a continuous process, hence Current Assetsare required continuously but the quantum of Current Assets
required may not remain constant throughout and may vary over
time.
Some part of the Working Capital is required continuously, which
is called FIXED Working Capital represents the MINIMUM levelof Current Assets.
Depending upon changes in production & sales, the need for
Working Capital over and above the Fixed Working Capital may
fluctuate.
Additional working capital required to support the changingproduction & sales level is called VARIABLE or TEMPORARY
Woking Capital.
Fixed & Variable Working Capital
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Overview of Working Capital Management
7
Fixed & Variable Working Capital (Contd.)
Time
Amo
untofWorkingC
apital
Variable
Current Assets
Fixed Current
Assets
Variable
Current Assets
Fixed Current
Assets
AmountofWorkingCapital
Time
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Overview of Working Capital Management
8
Approaches to Working Capital Financing
Based on the mix of Short Term(Spontaneous Sources/Current
Liabilities) and Long term sources of financing working Capital,
and the Fixed & Variable Current Assets, there are three
approaches to Working Capital Financing.
Matching Approach
Conservative Approach
Aggressive Approach
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Overview of Working Capital Management
9
Matching Approach
Expected life of an asset should
match the tenure of the
financing source.
Fixed assets should be
financed by long term sources
while the current assets should
be financed by short term
sources.
Applying to Working Capital
Management, Fixed Current
Assets should be financed by
long-term sources while theVariable Current Assets should
be financed by short-term
sources.
VariableCurrent Assets
Fixed Current
Assets
AmountofWorkingCapital
Time
Long Term
Sources
Short Term
Sources
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Overview of Working Capital Management
10
Under this approach, morereliance is on long-term
sources
Long term sources are
used to finance Fixed
Assets + Fixed Current
Assets + Part of the
Variable Current Assets.
Lower level of risk of
shortage of funds.
Conservative Approach
Long Term
Sources
VariableCurrent Assets
Fixed Assets
AmountofWorkingCapital
Time
Short Term
Sources
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Overview of Working Capital Management
11
Aggressive Approach
Under this approach, morereliance is on Short-term
sources of funds to finance
assets.
Part of Fixed Current Assets +
Temporary Current Assets are
financed by short-term
sources.
Variable
Current Assets
Fixed Assets
AmountofWorkingCapit
al
Time
Short Term
Sources
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Ov
erv
iew of Working Capital Management
12
Short term vs. Long term
Short-term funds are less costly and more flexible but atthe same time more Risky.
Hence, a Risk-Return trade-off has to be achieved while
deciding the financing mix.
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Overview of Working Capital Management 13
Determinants of Working Capital
Large nu
mber of factors influ
ence the working capital requ
irements.Each factor has different importance which varies over time as
well.
1. Nature & Size of Business: As compared with Total assets,
Trading companies require large investment in working capital
(than investment in Fixed Assets), while Utility companies suchas Power Generation Company, require low levels of working
capital and huge investments in Fixed Assets.
Size (Scale of operations) - Large company would require more
working capital.
2. Manufacturing Cycle: Longer the Manufacturing cycle, largerwill be requirement of working capital.
3. Sales Growth: As sales grow, more working capital would be
required, though a definite relationship is difficult to determine.
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Overview of Working Capital Management 14
4. Demand Conditions: For seasonal products, as demand varies, so does the
working capital varies.
During Boom periods, as demand picks up, not only the
variable, but the fixed working capital requirements also goes
up.5. Production Policy: Constant Production Policy would lead to
accumulation of inventory in off-season.
Cost of maintaining inventory
Risks- damage; no- off take.
To minimize - firm may choose to vary its production schedules.6. Price Level Changes: Increase in prices, calls for higher
investment in working capital. Though, the impact of increase in
general prices may be different on different companies.
Determinants of Working Capital
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Overview of Working Capital Management 15
7.O
perating Efficiency: A firm should make optimumutilisation of its resources at minimum costs. Efficient
utilisations of various factors of production, helps in reducing
the overall quantum of working capital.
8. Credit Policy: Liberal Credit Policy means high debtors,
high collection period, and high bad debts - hence moreworking capital would be required. Therefore, company
should follow a rational credit policy evaluate the credit
worthiness of customers and review them.
9. Availability of Credit from Suppliers: If a firm gets liberal
credit from its suppliers, the requirements of working capitalwould be less. Suppliers credit finances the firms inventory
and reduces the Also, if bank credit is easily available and on
favourable conditions, company would require less working
capital.
Determinants of Working Capital
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Inventory Management
16
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Inventory Management 17
Inventory Management
Forms ofInventory Raw materials basic input materials
Work-in-Progress Semi-manufactured goods
Finished Goods Completely manufactured goods,
ready for sale.
Need for holding Inventories:
Transactions motive: To facilitate smooth production &
sales operations
Precautionary motive: To guard against the risk of
unpredictable changes in demand and supply forces Speculative motive:To take advantage of price
fluctuations.
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Inventory Management 18
A firm is faced two conflicting needs:
To maintain large inventory to ensure efficient and smooth
productions and sales which shall tie-up funds in low yielding
assets & excessive carrying costs
To maintain low inventory to reduce costs and maximize
profitability which shall impair smooth production & marketing
functions
Both excessive and inadequate inventory levels are undesirable.
Thus, a trade-off between these two conflicting needs have to
be reached.
Objectives ofInventory Management
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Inventory Management 19
To trade-off the conflicting needs of a firm and to determine theoptimum level of inventory, techniques of Inventory Management
are used.
Economic Order Quantity (EOQ): What should be the size of
the Order placed each time by the firm?
Re-Order Point: When should the firm place the Order for the
inventory?
Inventory Management Techniques
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Inventory Management 20
Economic Order Quantity
Ordering Costs(Requisitioning; Order placing;
Transportation ; Receiving and
Inspecting Costs)
Ordering Costs increases
with the number of Orders
To reduce Ordering Cost,
place lesser no. of orders, but
each order should be of large
quantities.
Carrying Costs(Storage ; Insurance ; Obsolescence
; and Interest on Capital locked-up
in Inventory)
Carrying costs increase with the
inventory size.
To reduce Carrying Costs,
keep minimum inventory by
ordering smaller quantities in
each Order.
These two conflicting objectives are to be resolved
through Economic Order Quantity.
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Inventory Management 21
Total Costs(TC) = OrderingCosts + CarryingCost
where,
U=Annual Usage
Q= Quantity OrderedF= Ordering Cost Per Order
P= Price Per Unit
c= Carrying Cost (%)
=
=
No. of
Orders
Average
Inventory+v
Ordering Cost
Per Order vCarrying
Costs
+U FQ
v
Q c P2
v v
Economic Order Quantity
Quantity
Total Costs
Ordering Costs
Carrying Costs
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Inventory Management 22
Economic Order Quantity
Differentiating w.r.t Q and equating it to zero (for minimization), we get
Given:
Annual Usage (U) = 25,000 Units
Purchase Price (P) = Rs 2,750 per Unit Ordering Cost per order (F) = Rs 550 per Order
Carrying Cost (%) (c) = 25% of Purchase price
EOQ = 2UF/Pc = (2*25000*550)/(2750*25%) = 200 Units
2UFEOQ(Q )
cP
!
2 Annual Usage Ordering CostEOQ(Q )
Carrying Cost(%) Price per Unit
v v
!v
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Inventory Management 23
Assumptions of EOQ: The yearly forecast usage of an item of inventory is
known.
The usage of the item is even and uniform throughout
the period.
Inventory orders can be replenished immediately i.e.
there is no delay in placing and receiving the order.
Ordering and Carrying are the only 2 distinguishable
costs involved.
Cost per Order remains constant irrespective of heOrder size.
Carrying cost is a fixed %age of the Average Inventory
value.
Economic Order Quantity (Contd.)
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Inventory Management 24
To encourage customers to place larger orders,suppliers often offer Quantity Discounts.
Therefore, a Cost-Benefit Analysis has to be made
EOQ Quantity Discounts
Positive Impact Negative Impact
Discount will reduce the
per unit purchase price
By increasing the order
size, the no. of orders
shall reduce which shall
reduce the ordering costs.
As order size increases,
the average inventorysize will also increase,leading to an increase thecarrying costs.
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Inventory Management 25
1.Benefits: Reduction in Purchase Price:= Annual Usage v Discount
(UD)
Reduction in Ordering Costs:
= Decrease in No. ofOrders v Ordering Cost perOrder
Increase in Carrying Costs:
= Increase in Average Inventory v Carrying Cost
EOQ Quantity Discounts (Contd.)
*
1
U UF
Q Q
v
*
1Q (P D)c Q Pc
2 2
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Inventory Management 26
Given: Basic Data as in previous question Discount (D) = Rs 10 per Unit
Order Size to Avail Quantity Discount (Q1)=1,200Units
Impact of Quantity Discounts:
UD = (25,000*10) =2,50,000/-
{U/Q* - U/Q1} F = {25000/200 - 25000/1200}550 =57,292/-
{Q1(P-D)c/2 Q*Pc/2 }=
{1200(2750-10)25%/2 (200*2750*25%/2 }=3,42,250/-
Total Benefit = 2,50,000 + 57,292 - 3,42,250 =(34,958)
As the change in profit is NEGATIVE, hence should NOT go for
the higher order size and avail the quantity discount.
EOQ Quantity Discounts (Contd.)
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Receivables Management
27
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Receivables Management 28
When goods are sold on credit, finished goods areconverted into Receivables(or Debtors)
Granting of credit and creation of Book debts calls for
blocking of the firms funds.
Duration between the date of sale and the date of
payment has to be financed out of the working capital.
Quantum of a firms investment in debtors depends
upon: Volume of Credit Sales & Collection Period.
Receivables Management
Average
Investment in
Debtors
Daily Credit
Sales
Average
Collection
Periodv=
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Receivables Management 29
Competition: High competition, liberal Credit. Companys bargaining power: Monopoly product,
Brand & financial strengths - lower credit.
Buyers Requirements: e.g. industrial products.
Buyers status: Large Buyers demand better creditterms.
Relationship with dealers- to build long-term
relationship
Marketing tool: esp. when the product is new Industry Practice: past practice; small firms follow
large firms.
Why Firms Sell on Credit?
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Receivables Management 30
While establishing the Credit Policy, the followingvariables are considered:
1. Credit Standards refers to the criteria which a firm
follows in selecting customers for extending credit.
2. Credit Terms are the conditions under which a firm
sells goods on credit.
Credit Period
Cash Discount
3. Collections Efforts are the steps taken by a firm to
ensure timely realisation of receivables.
Credit Policy Variables
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Receivables Management 31
Tight Credit Standards: Mostly cash sales andcredit sales to the most reliable and financially strong
customers.
Such policy would result in Lower sales; Low bad-
debts; Low Collection Costs & Profits are forgone onlost sales
Liberal Credit Standards:
Higher sales, higher bad-debts, higher collection
costs.Thus, a trade-off between incremental profits and
incremental costs has to be considered.
Credit Standards
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Receivables Management 32
A firm may typically categorize its customers into:
Good Accounts Financially strong , prompt
payment.
Bad Accounts Financially weak, high risk
customers
Marginal Accounts Customers with moderate
financial health and risk.
Credit Standards (Contd.)
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Receivables Management 33
XYZ Ltd. is contemplating change in the credit standards. Ithas categorised the customers into three categories- A, B, andC .(A being the least risky customers). The company iscurrently selling to A & B category customers but now wants
to sell to category C as well.The potential sales, Average Collection Period & Bad-Debtratio relating to C category are Rs 160 Lacs, 90 days &10% respectively. Variable cost ratio is 75% and Post-tax rate
of return is 15%. Tax rate is 35%. Collection costs would be8% for this category.
Should the firm liberlise the credit standards?
Credit Standards (Contd.)
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Receivables Management 34
Credit Standards (Contd.)
Particulars Rs Lacs1. Incremental Sales 160.00
2. Incremental Contribution
( Sales*c)=160*25%
40.00
3. Incremental Bad-debts & Collection Costs
( Sales*b+d)=160*(10%+8%)
28.80
4. Incremental OPAT (2-3)*(1-t) 7.28
5. Incremental Investment in Debtors
( Sales/360)*ACP= (160/360) * 90
40.00
6. Marginal Rate of Return( OPAT/( Debtors) = 4/5
18.26%
7. Incremental PAT
( OPATless (r* Debtors)
1.28
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Receivables Management 35
Credit Terms
Credit Terms are the stipulations under which the firmsells on credit to customers. It includes:
(a) Credit Period; &
(b) Cash Discount.
Credit Period: Duration for which the credit is given.
net 40 customer is required to pay the net
amount due within 40 days.
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Receivables Management 36
Hotline Ltd. wants to increase its credit period from net, 30to net 60. This move is expected to push the sales fromRs.395 Lacs to Rs.550 Lacs & ACP from 45 days to 65 days.The companys contribution margin is 20% and collection
costs of 3% of Sales, bad-debt loss of 4% of Sales. If the firmspost-tax rate of return is 18% and tax rate as 35%, should thefirm change its credit terms?
Credit Terms (Contd.)
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Receivables Management 37
Credit Period (Contd.)
Particulars Rs Lacs
1. Incremental Sales ( Sales) 155.00
2. Incremental Contribution
( Sales*c)=155*20%
31.00
3. Incremental Bad-debts & Collection Costs
( Sales*b+d)=155*(4%+3%)
10.85
4. Incremental OPAT (2-3)*(1-t) 13.10
5. Incremental Investment in Debtors
(SalesN/360)*ACPN less (SalesO/360)*ACPO
=(550/360) * 65less
(395/360) * 45
49.93
6. Marginal Rate of Return
( OPAT/( Debtors) = 4/5
26.23%
7. Incremental PAT ( OPATless (r* Debtors) 4.11
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Receivables Management 38
Credit Terms Cash Discounts
As an incentive for customers to pay early. Firms offer adiscount 3/15, net 40 3% discount , if paid within 15
days or pay the full amount in 40 days.
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Receivables Management 39
Phoenix Shoes Ltd. presently sells Rs 242 Lacs worth of goodson net 30, but wants to change to 2/10, net 30. This willreduce ACP from 40 days to 25 days. No change in Sales is
expected due to this move. It is expected that 75% of thecustomers will take advantage of this changed credit terms.
If the firms post-tax rate of return is 16% and tax rate as35%, should the firm change the cash discount?
Cash Discounts(Contd.)
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Receivables Management 40
Cash Discounts (Contd.)
Particulars Rs Lacs
1. Cash Discount
(Sales* % Taking Discount*Discount%)
(242*75%*2%)
3.63
2. Post Tax Cost of Discount(Discount*1-t)
2.36
3. Incremental Investment in Debtors
(SalesN/360)*ACPN less (SalesO/360)*ACPO
= (242/360)*(25-40)
(10.08)
4. Net Change in PAT (SAVINGS Less COSTS)(r* Debtors)less Post Tax Cash Discount
= (16%*10.08)-2.36
(0.75)Savings
Loss
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Receivables Management 41
Collection Efforts
A firms collection programme aimed at timely collection
of receivables.
What the firm should do in case a customer has not paid
up & his credit period is over.
Monitoring the state of receivables;
Despatch of letters to customers whose due date is; polite vs.
strongly worded reminders
Telegraphic / Telephonic advice to the customers around the
due date
Personal visitsThreat of legal action to overdue accounts
Legal action against overdue accounts
Check the customers financial status- if weak, legal action
would only hasten his insolvency.
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Receivables Management 42
Factoring
Factoring involves transfer of the collection of
receivables and the related book-keeping (Sales
Administration functions by a firm (Client) to a financial
intermediary(Factor).
Sometimes the Factor also provides a line of credit
against the receivables of the firm.
Thus, Factoring is the sale of the book-debts by the firm
to a financial intermediary on the understanding that the
factor will pay for the debts as and when they are
realized/collected or on a guaranteed payment date.
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43
Process of Factoring
Client
(Seller)
Factor
Customer
(Buyer)
1
2b
2a54
63
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44
Process of Factoring
1. The client makes a Credit Sale to its customer.2a.Client sends the customers account to the Factor.
2b.Client simultaneously informs the customer about hiscontract with the factor.
3. Factor makes part-payment of the credit sales to the client
after adjusting for commission and interest on the advance.4. Factor maintains the Sales Ledger & follows-up for payment
with the customer.
5. Customer remits the amount due to the Factor.
6. Factor makes the final payment to the client , when theamount is collected or on the guaranteed payment date.
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Services provided by Factor
Factor typically provides the following services:
a. Maintenance of Sales Ledger
b. Collection of Receivables
c. Financing of the Client
For services (a) & (b), the factor charges Factor
Commission, which is a % age of the value of receivables
purchased, usually collected up-front.
For service (c), the factor charges Factor Interest for the
duration between the date of advance payment & the date of
collection or the guaranteed payment date.
Factor does not provide 100% finance. It maintains a
margin(Factor Reserve) to provide for contingencies.
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Forms of Factoring
Depending upon the features built into the factoring contract
between the Factor and the client, various types offactoring are as follows:
(a) Recourse Factoring: Factor has recourse to the client in
case of bad-debts.
(b) Non-Recourse Factoring: Factor assumes the credit risk.(c) Advance Factoring: Factor pays 75-80% in advance,
balance upon collection or on the guaranteed payment
date.
(d) Maturity Factoring: Payment on guaranteed paymentdate or on collection.
(e) Full Factoring: Non-Recourse, Advance Factoring.
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Cost Benefit Analysis
Given:Credit Sales 6,000,000 p.a.
Average Collection Period 90 days
Bad debt Loss 1.50%
Collection Costs 120,000 p.a.
Factor Commission 2.25%Factor Interest 18% p.a.
Factor Reserve 15%
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Cost Benefit Analysis
1. Average Investment in Debtors 1,500,000(Daily Credit Sales * ACP)
2. Factor Commission 33,750
(Av. Receivables*Factor Commission)
3. Factor Reserve 225,000
(Av. Receivables*Factor Reserve)
4. Maximum Advance (1-2-3) 1,241,250
5. Factor Interest 55,856
(Max Advance * Factor Interest for Days used)
6. Net Amount Payable (4-5) 1,185,394
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Cost Benefit Analysis
A. Annualized Factoring Costs:
- Factor Commission 135,000
- Factor Interest 223,425
TOTAL FACTORING COSTS 358,425
B. Costs Avoided Due to Factoring:
- Collection Costs 120,000
- Bad Debts 90,000
TOTAL SAVINGS 210,000
C. Net Cost (A-B) 148,425D. Funds Made available by Factoring 1,185,394
E. Effective Cost of Factoring (C/D) 12.52%
Effective Costs