The Implicit Cost of Trade Credit to the Customer Trade credit is often stated in terms of a rate of discount, a discount

The Implicit Cost of Trade Credit to the Customer Trade credit is often stated in terms of a rate of discount, a discount

period, and a net period when payment in full is due. The effective cost of trade credit to the customer can be calculated by determining first the effective interest cost for the period of credit and then placing this effec- tive cost on an annual basis so that we can compare it with the cost of other forms of credit.

If the credit terms are stated as “2/10, net 30,” this means that the customer can take a 2% discount from the invoice price if they pay within

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ten days, otherwise the full price is due within thirty days. If you purchase an item that costs $100, you would either pay $98 within the first ten days after purchase or the full $100 price if you pay after ten days.

The effective cost of credit is the discount forgone. For a $100 pur- chase, this is $2. Putting this in percentage terms, you pay 2% of the invoice price to borrow 98% of the invoice price:

0.02 Cost of credit = r = ----------- = 0.020408 or 2.0408% per credit period

The effective annual cost is calculated by determining the compounded annual cost if this form of financing is done through the year. Assuming that payment is made on the net day (thirty days after the sale), the credit period (the difference between the net period and the discount period) is twenty days and there are t = 365/20 = 18.25 such credit peri- ods in a year. The effective annual cost is:

Effective annual cost t = ( 1 + r ) – 1

= 18.25 ( 1 + 0.020408 ) – 1 = 44.58% per year The flip-side of this trade credit is that the firm granting credit has an

effective return on credit of 44.58% per year. Credit and the Demand for a Firm’s Goods and Services

When a firm decides to grant credit, it must consider the effect on its pric- ing and its sales. Let’s return to the case where your competitor offers credit terms of payment in thirty days and your firm does not. While on the surface it may seem that your competitor has an advantage, this may not be. What if your competitor also charges higher prices? Perhaps these prices are just high enough to compensate it for the expected costs of bad debts and the time value of money. Does this mean that your firm will increase sale if they extend credit? Yes, if your firm does not change its prices. Maybe, if your firm increases prices when it extends credit.

To analyze the effect of extending credit, you must consider a num- ber of factors:

■ The price elasticity of your goods and services. How price sensitive are sales? ■ The probability of bad debts. When you extend credit, how likely is it that some customers may pay late or never pay? How much compensa- tion do you require to bear this risk?

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■ When customers are most likely to pay. If you offer discount terms, will all your customers pay at the end of the discount period? What propor- tion of your customers will pay within the discount period?

As you can see, there are many variables to consider and these vari- ables differ from firm to firm and industry to industry. An understanding of your market and of your customers’ needs is required in analyzing the effects of a change in credit policy.