Calculating the Cost of Trade Credit

This lesson is part 10 of 11 in the course Working Capital Management

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:

$Cost\ of\ Trade\ Credit = (1+\frac{Discount}{1-Discount})^{\frac{365}{Days\ after\ discount\ period}}-1$

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.