Practise IB Business Management SL/HL 3.7.6 by applying cash flow problem strategies concepts to exam-style questions.
Grunsburg Textiles (GT)
Grunsburg Textiles (GT) is a textile company founded by the paternalistic leader Henrik Steiner. As the company grew, it became very committed to corporate social responsibility (CSR). "Our aims," GT says on its website, "include making profits, providing safe and secure employment, contributing to society through investment in environmentally friendly production practices and supporting ethical causes". Many people believe that GTs success is tied to its reputation for taking care of its employees and for its commitment to CSR.
In 2015, GT purchased €44 million in new environmentally friendly equipment. It financed the purchase with a bank loan. GT originally forecasted that the new equipment would generate €8 million in annual net cash flow. Instead, the actual increase in GTs annual net cash flow from the new equipment was only € 6 million. The Chief Financial Officer (CFO), Elaine, warned Henrik that unless net cash flow increased significantly, the average rate of return (ARR) would be significantly lower than originally forecasted.
G T is struggling to make the loan payments and to have sufficient working capital. Elaine determined that one way to shorten the working capital cycle is debt factoring. However, when she approached several (debt) factors, she was discouraged by their proposed discount rates.
Elaine knows that the situation is worse than she had warned. If the economy were to weaken and revenue to decline, she believes that the company could go out of business. Proposals for a solution include cutting back on GTs commitment to its employees and CSR practices.
With reference to G T, explain one advantage and one disadvantage of debt factoring.
With reference to GT, explain one advantage and one disadvantage of debt factoring.
Advantages of debt factoring. The business (GT):
- does not have to carry the invoice (receivable) for the duration (or longer) of the credit terms but rather receives cash immediately upon sale to the factor. Thus, factoring reduces the working capital requirements.
- does not have to provide any collateral. Unlike when taking out a revolving or seasonal line of credit, the business does not have to provide a lender with collateral. As a result, the business may use any assets it has available for collateral for other borrowing requirements.
- does not have the credit risk of the debtor, as the factor assumes the credit risk (though, over time, if GT routinely sold uncollectable invoices, the factor would adjust its discount rate to account for credit losses or not purchase invoices from certain customers). Without the credit risk, the business does not have to have a collections employee/department and will not have credit losses.
The disadvantages of factoring include:
- The high cost. While the discount rate may vary, the discount rate used by debt factors almost always equates to a higher rate of interest than a loan. Thus, the cost of debt factoring is high.
- Loss of control. Collection of the invoice is in the hands of the factor, who may or may not use collection methods consistent with the approach of the business selling the invoices. Customer relations could suffer if the factor uses harsh collection methods or a negative tone in collection.
- Damage to reputation. In general, some stigma is attached to reliance on debt factors, as it alerts customers that the business (GT) lacks working capital or the ability to borrow. A poor reputation weakens a firm's ability to negotiate and may mean loss of customers (businesses want suppliers who are reliable).
Accept other relevant advantages and disadvantages.
Mark as 2+2.
Accept any other relevant advantage / disadvantage.
Accept any other relevant explanation.
Mark as 2 + 2.
Award [1] for each correct advantage / disadvantage identified or described and [1] for a relevant explanation with application to GT. Award up to a maximum of [2].
[2] cannot be awarded per advantage / disadvantage if the response lacks either explanation and / or application.
For example:
- For an identification or a description of an advantage / disadvantage with or without application [1].
- For explanation of an advantage / disadvantage with no application [1].
- For explanation of an advantage / disadvantage and application [2].