We have seen that trade credit is a source of funds to the buyer because the buyer does not have to pay for goods until after they are delivered. If the firm automatically pays its bills a certain number of days after the invoice date, trade credit becomes a spontaneous (or built-up) source of financing that varies with the production cycle. As the firm increases its production and corresponding purchases, accounts payable increase and provide part of the funding needed to finance the increase in production.
For example on average, a firm purchases $5,000 worth of goods a day from its suppliers on terms of â€œnet 30â€?. The firm will thus be provided with $150,000 worth of financing from accounts payable (30days x $5,000 per day = $150,000) if it always pays at the end of the net period. Now, if purchases from suppliers should increase to $6,000 per day, $30,000 of additional financing will be provided as the level of accounts payable ultimately rises to $180,000 (30days x $6,000 per day).
Similarly, as production decreases, accounts payable tend to decrease. Under these circumstances, trade credit is not a discretionary source of financing. It is entirely dependent o the purchasing plans of the firm, which, in turn, are dependent on the firmâ€™s production cycle. In examining trade credit as a discretionary form of financing we want to specifically consider situations in which (1) a firm does not take a cash discount but pays on the last day of net period, and (2) a firm pays its bills beyond the net period.
Payment on the Final Due Date
In this we assume that the firm forgoes a cash discount but does pay its bill on the final due date of the net period. If no cash discount is offered there is no cost for the use of credit during the net period. On the other hand, if a firm takes a discount, there is no cost for the use of trade credit during the discount period. If a cash discount is offered but not taken, however, there is definite opportunity cost. If the terms of sale are â€œ2 / 10, net 30,â€? the firm has the use of funds for an additional 20 days if it does not take the discount but pays on the final day of the net period. For a $100 invoice, it would have the use of $98 for 20 days, and for this privilege it pays $2 (This is the result of paying $100 thirty days after the sale, rather than $98 ten days after the sale). Treating this situation as equivalent to a loan of $98 for 20 days at a $2 interest cost, we can solve for the approximate annual interest rate (X%) as follows:
$2 = $98 x X% x (20days/365days)
X% = (2/98) x (365/20) = 37.2%
Thus, we see that trade credit can be a very expensive form of short-term financing when a cash discount is offered but not accepted.
The cost, on an annual percentage basis, of not taking a cash discount can be generalized as
Approximate annual interest cost =
% discount Ã· (100%âˆ’% discount) x 365 days / (payment date â€“ discount period) —————–Equation 1
Making use of equation 1, we can see that the cost of not taking a discount declines as the payment date becomes longer in relation to the discount period. Had the terms in our example been â€œ2 / 10, net 60,â€? the approximate annual percentage cost of not taking the discount, but rather paying at the end of the credit period, would have been
(2/98) x (365/50) = 14.9%
The relationship between the annualized implicit interest cost of trade credit and the umber of days between the end of the discount period and the end of the net period is shown in equation 1.We assumes â€œ2 /10â€? discount term. For situation in which payment is made on the final due date, we see that the cost of trade credit decrease at a decreasing rate as the net period increases. The point is that if a firm does not take a cash discount, its cost of trade declines with the length of time it is able to postpone payment.