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Pledging Accounts Receivable

The Pledging Process

Second National Bank of Bryn Mawr is analyzing the accounts receivable

ledger of Crowe Company, an educational publisher, to find acceptable
collateral for a pledge or accounts receivable. Each of Crowe's accounts
receivable, along with its age and average payment period, is given in Table
15W.2 (below). Because Crowe extends credit terms of 2/10 net 30 EOM, the
bank eliminates from further consideration all accounts that are currently
overdue (those whose age is greater than 30 days). This immediately
eliminates the accounts of customers C, E, and I.

The second step in the bank's evaluation process is to analyze the historical
payment patterns of the customers. After calculating the average payment
period for each customer (given in the last column of Table 15W.2), Second
National Bank decides to eliminate customer B, whose account, although not
currently overdue, normally requires 60 days to collect. Having eliminated
the accounts of customers B, C, E, and I, the bank is left with $45,000 of
acceptable accounts from customers A, D, F, G, and H (who owe $10,000,
$4,000, $6,000, $14,000, and $11,000, respectively). Crowe Company
therefore has $45,000 of acceptable accounts receivable collateral. Each
account that is used as collateral is marked in Crowe Company's ledger, and
a list of the billing dates and amounts is kept by the bank.

TABLE 15W.2: Crowe Company's Accounts Receivable

Account Average payment
Customer Agea
receivable period
A $10,000 20 days 35 days
B 8,000 5 60
C 15,000 50 45
D 4,000 14 30
E 3,000 70 60
F 6,000 10 20
G 14,000 3 10
H 11,000 23 10
I 3,000 45 45

Number of days since the beginning of the credit period.

Adjusting the Dollar Value of Selected Accounts Receivable

The $45,000 of acceptable accounts receivable selected by Second National

Bank of Bryn Mawr from Crowe Company's books must be adjusted for
returns and allowances. The bank decides, after evaluating the company's
accounts, that a 5 percent adjustment is appropriate. After this adjustment
Crowe Company has acceptable collateral of $42,750 [$45,000 x (1 - .05)].

Applying the Percentage to Be Advanced

After a reexamination of Crowe Company's acceptable accounts receivable

and general operations, Second National Bank of Bryn Mawr decides to
advance 85 percent of the value of the adjusted acceptable collateral. This
means that the bank will lend the company about $36,338 (42,750 x .85
Use of Factoring Account

Ross Company, a manufacturer of aluminum baseball bats, has sold five

accounts to a factor. All the accounts were due September 30. Each account,
its amount, and its status on September 30 follow.

Account Amount Status

Collected Sept
A $10,000
Collected Sept.
B 4,000
Collected Sept.
C 50,000
D 8,000 Uncollected
Collected Sept.
E 12,000

As of September 30, the factor has received payment from suppliers A, B, C,

and E. It therefore has already taken its fee, or discount, on each account
and remitted the balance to Ross Company. On September 30, the factor has
to remit the $8,000 due on account D, less the factoring fee on this account,
even though it has not yet been collected. If account D is uncollectable, the
factor will have to absorb the loss.
Factoring Cost

Graber Company, a producer of children's rainwear, has recently factored a

number of accounts. The factor holds an 8 percent reserve, charges on and
deducts from the book value of factored accounts a 2 percent factoring
commission and charges 1 percent per month interest (12 percent per year)
on advances. Graber wishes to obtain an advance on a factored account
having a book value of $1,000 and due in 30 days. The proceeds to the
company are calculated as follows:

Book value of account $1,000

Less: Reserve (8% x $1,000) 80
Less: Factoring commission (2% x
Funds available for advance $900
Less: Interest on advance (1% x
Proceeds from advance $891

The firm receives $891 now and expects eventually to receive the $80
reserve. The exact method that is used to calculate the amount of the
advance will vary, depending on the terms of the factoring agreement.
Because Graber Company must pay the interest in advance, the effective
annual interest cost of this transaction is not 12 percent but 12.12 percent
[($9 ÷ $891) x 12]. Of course, if one includes both the factoring commission
of $20 and the interest of $9, the annual factoring cost for the transaction
would be approximately 39 percent [($29 ÷ $891) x 12].

Floating Inventory Liens

Prescott Toy Company, a manufacturer of inexpensive plastic children's toys,
needs a loan of $125,000 for 60 days. The company's primary bank has told
management that a loan secured under a floating inventory lien is possible.
The annual interest rate would be about 14 percent, which is 5 percent
above the prime rate. Funds would be advanced up to 40 percent of the
average book value of the secured inventory. This means that the company
would have to put up $312,500 in book value of inventory as collateral--the
loan required divided by the loan advance ratio ($125,000 ÷ .40). The cost of
this loan is $2,917 ($125,000 x 14% x 2/12). This is equivalent to an effective
rate of 2.33 percent for 2 months ($2,917/$125,000) or the stated 14
percent rate annually [2.33% x (12 ÷ 2)] assuming that this is a single

Warehouse Receipt Loans

GIT Industries, a manufacturer of adhesive products, needs to borrow
$80,000 for 1 month to support a seasonal expansion of inventory. The
financial manager has approached a commercial finance company about
borrowing under a field warehouse receipt arrangement. The terms of the
loan are prime plus 3 percent interest per annum, which makes the stated
interest rate about 12 percent. Management thinks the prime rate will
remain stable during the period of the loan. The finance company will loan
80 percent of the book value of inventory put up as collateral. The loan
would require a warehousing charge of $500 per month plus 1 percent of the
value of the inventory warehoused.

To be able to borrow $80,000, GIT Industries must provide collateral of

$100,000--the amount needed ($80,000) divided by the loan ratio (0.80).
The cost of the field warehouse receipt loan for 1 month is determined as

Field warehouse charge $ 500

1% of collateralized inventory
Loan interest (12%/12 x
Total cost $2,300

The effective interest rate on this loan is 2.875 percent ($2,300 ÷ 80,000) for
1 month. The effective annual cost of the loan is 34.5 percent (2.875% x 12)
assuming that this is a single transaction.