Analyse the disadvantages to a business of using debt factoring to improve its cash flow.

Mark scheme

Marking points from the official mark scheme (May/June 2020). The mark or mark type is shown in brackets.

1. Answers could include:
2. Debt factoring is when a business sells its debts to a third party.
3. Disadvantages:
4. • The full value of the debt is not paid by the debt factor (usually about 80% of the value of the debt is received).
5. • Debt factors usually refuse to take the long-term bad debts so the business still has debts that it might struggle to recover.
6. • Customers might not like having their debt sold to a third party because they will now have to deal with someone outside of the original business they dealt with. Customers might not want to deal with the business again.
7. • Use of debt factoring could send a signal to stakeholders that the business has liquidity problems. This could impact on the relationship of the business with its stakeholders. For example, if it is a public limited company, shareholders may begin to sell shares believing that the business is no longer a good investment.
8. Possible answers might include:
9. This can depend on why the ratios are being compared and by whom – if it is a potential investor then they will need a lot more information.
10. Comparisons can only be reasonably made between business in the same industry and of the same size. E.g. a large business is likely to have more purchasing power than a small one and is likely to receive discounts which reduces costs. This will be reflected in ratio analysis.
11. Ratios can show trends over time and between businesses but should be used with caution because:
12. • The accounting techniques used differ between businesses – different methods of depreciation can affect the profitability ratios making it difficult to make like-for-like comparisons.
13. • Ratios are calculated using past information. The present situations in different businesses might be quite different. One business might be researching and introducing a new product shortly which could alter its ratios significantly now and in the future.
14. • Ratios are not a certain indication of what is happening now or in the future.
15. • Ratios do not give any qualitative information such as the level of motivation of the employees. This can impact on future performance and therefore ratios.
16. • The values used from the statement of financial position are taken on one specific day. The results of the ratios might have been better or worse using values from any other day.
17. • Ratios can give useful trends and comparisons but should be treated with caution with as many underlying factors are also considered.