Trade credit is an important source of liquidity and financing for any company. The company needs to manage its accounts payables effectively and take advantage of the credit period to minimize its cost of funds.

An important decision here is whether it is beneficial for the company to pay within the discount period or pay only by the end of the payment due period.

A company can evaluate trade discounts using the following formula:

During the discount period, the cost of funds is 0, so the company can benefit by paying at the end of the discount period. After the discount period the cost of credit increases for the buyer and then starts decreasing till the final due date reaches.

Let’s take an example to understand this.

Assume that the trade credit terms are 2/10, net 60. This means that the customer will get a discount of 2% if paid within 10 days, and if discount is not availed the amount is due in 60 days.

If the company pays on 30th day and on 50th day, the cost of trade credit will be:

Cost of trade credit (payment on day 30) = (1+0.02/0.98)^(365/20) – 1 = 44.58%

Cost of trade credit (payment on day 50) = (1+0.02/0.98)^(365/40) – 1 = 20.24%

As you can see, after the discount period is over, the cost of trade credit comes down as the net day approaches, and it will be the lowest on the net day.

The company can compare its cost of funds or short-term investment rate with the cost of trade credit to make a decision about availing the discount. If the cost of funds or short-term investment rate is lower that the cost of trade credit, the company will benefit by paying its bills within the discount period.

Is the cost infinity large at the time just pass discount date?

Basically yes. You effectively pay 2% (take it as a cost) for that increasingly small proportion of time for delaying your payment. Therefore, intuitively, the closer you get to the boundary of the discount, the higher the cost.

Take it this way: would you rather have 2% discount or delay your payment for a period of time? That depends on how much you can earn with delaying your payment. The cost of trade credit is thus often compared to money-market lending costs (or other cost of funds for the company).

For a 2/10 net 120: the cost of trade credit is 6.93% when paying on the 120th day. If your cost of short-term funds are higher, you would benefit from delaying your payment.