ACCOUNTING PRINCIPLES I-FINANCIAL CHAPTER 7 WRITING ASSIGNMENT Gerard Appliances

Question

ACCOUNTING PRINCIPLES I-FINANCIAL CHAPTER 7 WRITING ASSIGNMENT Gerard Appliances, Inc., is a small manufacturer of washing machines and dryers. It sells its products to large, established discount retailers that market the appliances under their own names. Gerard generally sells the appliances on trade credit terms of n/60, but if a customer wants a longer term, it will accept a note with a term of up to nine months. At present the company is having cash flow troubles and needs $10 million immediately. Its Cash balance is $400,000, its Accounts Receivable balance is $4.6 million, and its Notes Receivable balance is $7.4 million. Prepare a memo to the chief financial officer of Gerard explaining how the company can use its accounts receivable and notes receivable to raise the cash it needs. Explain the advantages and disadvantages of using the receivables to raise the cash.

Explanation / Answer

To

Chief Financial Officer

Gerard Appliances, Inc.

_____

Use of Factoring to Obtain Funds

_____

This is in regards to the cash shortage situation that we are experiencing at this point of time. We need $10 million cash on an immediate basis and most of our money is blocked in accounts and notes receivable. Also, we need cash to manage day to day operations of the company. Converting these receivables into cash will take a lot of time.

As we have no other means of obtaining finance, we have an option to sell these receivables completely or obtain loans against invoices which are yet to be paid by our customers. This will help in quick conversion of receivables and will provide us with immediate cash (which may be around 80% of the value of receivables sold). Also, if we are able to sell the receivables completely (rather than obtaining loans against them), we will not have to worry about any defaults (in payment) that may arise as a result of non-payment by any debtor (customer). Such risks will automatically get transferred to the factor (the company/party that will be buying our receivables). Also, the constant need to follow up with customers for timely realization of payment (s) will be reduced. We will be able to focus more on business operations and our growth and expansion objectives. However, as per our understanding, the cost of obtaining funds by selling receivables would be higher in comparison to obtaining loans against invoices. It is because the factor will be assuming the complete risk for all of the receivables that are sold by us and therefore, would deduct a higher percentage as its commission. Further, it is highly likely that the factor may be more interested in extending funds against invoices rather than buying receivables completely. So, that would depend on the evaluation of the quality of our receivables by the factor. If we are confident that our customers will not default on their payments, we should consider obtaining loan against invoices as we would be able to obtain funds at a lower cost in such a case. However, based on market research, the cost of obtaining funds through any means of factoring will be higher than the cost of obtaining business loans through banks/financial institutions.

Based on the above information, we need to take a decision as to whether we should proceed ahead with this process of factoring our receivables or not. Kindly let us know in case you require any further information.

Thanks

Finance and Accounting Department

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