Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or

Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or

services. Trade credit arises spontaneously as the customer acquires goods or services and promises to pay some time in the future. From the seller’s point of view, trade credit is a way of making more sales. From the customer’s point of view, trade credit is an easy way to finance the purchase of goods. Once a satisfactory relationship is established between the seller and the customer, trade credit is granted automati- cally. For the seller, trade credit creates accounts receivables; for the cus- tomer, trade credit creates accounts payable.

Cost of Trade Credit There is no explicitly stated interest rate for trade credit. But there is an

implicit cost. Suppliers allow customers to pay at a later date but offer a discount if payment is made within a specified time period. The implicit cost is the difference between the cash price (the cost after the discount) and the full invoice price. Trade credit terms customarily state the dis- count terms: the discount percentage, period in which the payment must

be received to take advantage of the discount, and the final due date.

For example, the terms “1/15, net 30” means that if payment is made during the first 15 days, there is a 1% discount from the invoice amount, otherwise full payment of invoice amount must be paid by day

30. Exhibit 21.4 shows a time line that represents the amounts due on a $100 purchase. The figure shows that if you pay on or before the fif- teenth day, your cost of the goods is $99. If you pay after the fifteenth day, your cost of the goods is $100. The credit period begins after day

15. You start incurring a higher cost on day 16, and the cost of the credit is $1 (the difference between $100 and $99). The credit period covers the number of days payment is delayed beyond the fifteenth day.

EXHIBIT 21.4 Time Line of Payments Required Under Terms 1/15, Net 30

Management of Short-Term Financing

The effective cost of credit depends on the number of days payment is delayed beyond the fifteenth day. Because terms of credit from differ- ent suppliers may be stated using different credit periods and because we may wish to compare the cost of alternative forms of credit, it is con- venient to calculate the effective cost of trade credit for some common period, say a year.

What is the effective annual rate of using trade credit if terms are 1/15, net 30, and payment is made on the tenth day? Because the cash price is paid on day 10, there is no cost of credit—EAR = 0%.

What if payment is made on the twentieth day under these terms? The rate of interest is 1% of invoice price. But how much are you really borrowing? If you paid within fifteen days from the date of purchase, the cost is $99. If you pay after fifteen days, the cost is $100. Therefore, by paying on day 20, you are paying $1 to borrow $99 for five days:

$1 = 0.0101 or 1.01% per period (5 days in this case)

r = ----------

$99 If you pay on day 20, you have effectively borrowed funds for five days

(from day 16 through day 20). How many five-day periods (compounding periods) are there in a year? There are 73 ( t = 365/5). The effective annual cost of trade credit if you pay 20 days after your purchase is:

EAR = (1 + 0.0101) 73 − 1 = 1.0826 or 108.26% per year. What this means is that you effectively borrowed $1 from the sixteenth

day to the twentieth day and paid an annual rate of 109% for these five days.

What if you pay on the “net” day—thirty days after purchase? The interest rate for the credit period remains the same, since you are still paying 1% of the invoice price to borrow 99% of the invoice:

0.01 r = ----------- = 0.0101 or 1.01% per period (15 days in this case)

0.99 But the credit period is now fifteen days, so there are fewer compound-

ing periods in a year, 24.33 ( t = 365/15). The effective annual rate when you pay 30 days after the purchase is:

EAR = (1 + 0.0101) 24.33 − 1 = 0.2770 or 27.70% per year.

MANAGING WORKING CAPITAL

EXHIBIT 21.5 Effective Annual Cost of Trade Credit Financing with Terms of 1/15,

Net 30, with Payment 18 to 50 Days After the Sale

As the credit period is lengthened, the cost of trade credit declines. Why? The later within the credit period that you pay your bill, the longer you have the creditor’s $1 and the lower the effective annual cost. The cost of credit for the credit period remains the same once you pay after the fifteenth day and through the thirtieth day, 1.01%, but the credit period lengthens. You can see this in Exhibit 21.5, where the effective annual rate of trade credit under these terms is plotted against the number of days payment is made after the purchase date, starting

with the eighteenth day. 1 The effective rate drops swiftly as we stretch out our payments beyond the discount period.