Cost of trade credit

What does skipping a prompt-payment discount cost?

Trade credit is the time a supplier lets a customer wait before paying. Suppliers often add a prompt-payment discount for paying early. Taking that discount is cheap money. Skipping it is a loan from the supplier, and the interest is the discount you did not take.

Credit terms are written d/D, net N. “2/10, net 30” means 2% off if paid within 10 days; otherwise the full amount is due on day 30.

Credit terms d/D, net Nfor example 2/10, net 30

• d: the discount Memorize 2% off the invoice
• D: the discount period Memorize pay within 10 days to get it
• N: the net period Memorize full amount due on day 30
• Extra days = N − D Memorize 30 − 10 = 20 days of borrowing
  • Cost of the loan Memorize the discount forgone

Skipping the discount buys N − D extra days of credit. For 2/10, net 30 that is 30 − 10 = 20 days.

What does the 20-day loan cost? On an invoice of 100, paying early costs 98 and paying late costs 100. The company pays 2 to keep 98 for 20 days, so the cost of the period is 2 ÷ 98 = 2.04%, which is d ÷ (1 − d). A year has 365 ÷ 20 such periods, and the supplier loan rolls over each time, so the periodic cost compounds. The effective annual rate of trade credit is:

$$\text{EAR} = \left(1 + \frac{d}{1 - d}\right)^{365 / (N - D)} - 1$$

Here $d$ is the discount as a decimal, $D$ the discount period and $N$ the net period, both in days.

When should the company borrow instead?

If the EAR of forgoing the discount is higher than the cost of a bank loan, the company is better off borrowing from the bank, paying the supplier within the discount period, and repaying the bank later. It keeps its cash and avoids the supplier’s high implied rate.

Exam tip A small discount over a few weeks is a big annual rate. Almost any bank loan beats forgoing a 1% or 2% discount.

Go deeper Why the formula compounds, and why not to use the shortcut

The supplier loan is renewed every cycle: each time the company skips the discount it pays the periodic cost again. Over a year the cost therefore compounds, as for any interest rate converted to an effective annual rate. A simple approximation, d ÷ (1 − d) × 365 ÷ (N − D), ignores the compounding. For 1/10, net 50 it gives 1.0101% × 9.125 = 9.22% against 9.6% for the compounded form. The shortcut always understates, and the exam answer is the compounded EAR.

What is the cost in cash?

When a question asks for the cost of the forgone discount in money rather than as an annual rate, apply the discount to the payables. That is the “liquidation cost” of using payables as a source of cash.

$$\text{Cost} = d \times \text{Payables}$$

How do you pick the cheapest source in a pinch?

Compare the cost of each source for the same cash need. A source’s cost is what the company gives up to raise a given amount of cash.

$$\text{Amount sold} = \frac{\text{Cash needed}}{1 - c}$$

What shapes a company’s short-term funding choices?

Short-term funding strategy means deciding when to borrow and in what form. The aim is flexibility: a company that fails to explore its options or to use the cheaper ones is more likely to face high financing costs or even distress, where it cannot borrow from any source.

Short-term funding choiceswhen to borrow and in what form

• A prudent strategy Use it four aims
  • Diversified sources of credit avoid one lender or one type
  • Capacity for peaks seasonal needs, planned growth
  • Competitive rates and terms and how they move
  • All costs counted implicit (forgone discounts) and explicit
• What shapes the options Use it five influences
  • Size big firms reach short-term markets
  • Creditworthiness approval, rate and restrictions
  • Legal setting weaker systems lean on trade credit
  • Regulation caps or special sources
  • Underlying assets inventory as collateral

A prudent strategy keeps enough diversified sources of credit (many firms have one main source, such as trade credit or a credit facility, and should have a backup), secures enough capacity for peak seasonal needs and planned growth, checks that rates and terms are competitive, and counts both implicit costs (forgone discounts) and explicit ones in the effective cost of borrowing.

What is available depends on the firm:

• Size. A small private firm may be limited to credit from a single bank, while a very large firm can use short-term debt markets. Many alternatives have a minimum size or fixed costs that make them too costly for small and mid-sized companies.
• Creditworthiness. A firm’s creditworthiness decides whether a loan is approved, the rate, and whether the loan carries restrictions, such as limits on selling or using assets.
• Legal setting. Firms in markets with less developed legal systems may have fewer funding sources and lean on supplier trade credit.
• Regulation. Utilities and banks can be limited in how much and what they borrow, but may have special sources, such as central bank funding for banks.
• Underlying assets. Assets such as inventory may be good collateral for secured short-term funding.

Planning helps for any firm. Forecasting cash over a cycle and beyond, matching debt maturities to expected receipts and spacing maturities over time all lower the risk of distress in adverse markets.