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.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
Show more