When preparing financial projections one of the parameters that needs to be entered is the days payable outstanding. This represents the average number of days it takes to pay a supplier. The lower the number of the days payable outstanding, the quicker suppliers are being paid, and the higher the working capital and additional funding requirements will be.
Supplier trade credit is a form of finance available to the business and while it is important to try and keep the credit terms offered as high as possible, suppliers will often offer an accounts payable discount in return for an early settlement of their invoices.
For example, a business which normally pays its suppliers in 30 days might be offered a 1% early payment discount if the invoices are settled within 14 days. The impact of this in the financial projections is to reduce the days payable outstanding from 30 days to 14 days, resulting in an increase in the working capital and funding requirements as cash flows out of the business to make the payment 16 days earlier.
On the face of it not taking the cash discount and keeping the days payable outstanding as high as possible, thereby reducing the funding requirements, appears to be the sensible decision for a cash strapped startup business to make. However, the true cost of maintaining the days payable outstanding at the higher level needs to be understood to fully appreciate the impact and cost of not taking the cash discount from suppliers.
Cost of Trade Credit Example
Suppose for example, a business receives invoices from suppliers for the amount of 5,000 with 30 day terms offering a 1% early payment discount for settlement within 14 days (1/14 net 30 terms).
If the business chooses not to take the early payment discount due to a shortage of available cash, then it keeps the cash it would have paid 4,950 (5,000 – 5,000 x 1%) for an extra 16 days (30 days – 14 days), and loses the discount of 50. Looked at another way, the cost of having the cash of 4,950 available for an extra 16 days is the discount the business gives up of 50.
If this cost (interest) is expressed as a rate, then the rate for not making the payment early is calculated as follows:
Interest rate for 16 days = Interest / Principal Principal = 4,950 (amount paid to the supplier) Interest = 50 (discount taken) Term = 16 days (normal terms - discount terms) Interest rate for 16 days = 50 / 4,950 = 1.01%
This is the rate for having the use of the funds for an extra 16 days, to convert this to an annual percentage rate (APR) we simply divide by 16 to convert it to a daily rate, and then multiply by 365.
Interest rate for 16 days = 1.01% Daily interest rate = 1.01% / 16 Annual interest rate = (1.01% / 16) x 365 Annual interest rate = 23.04%
However, this is the cost if the business does not take the early payment discount on only one occasion. If the business does not take the discount repeatedly throughout the year, then the effective annual rate (EAR) represents the effective cost of trade credit as a result of the compounding and is given by the following formula:
EAR = (1 + i / m )m - 1
EAR = Effective annual rate
i = Annual nominal rate of interest
m = Number of compounding periods in a year
In this effective interest rate formula, the annual nominal interest rate i is the rate we calculated above without compounding (23.04%), and the number of compounding periods in the year is simply the number of times the discount is not taken and the cash is retained for the extra days each year. Since in our example the cash is retained for an extra 16 days each time, then the number of compounding periods in a year is 365 / 16 or 22.81.
The effective interest rate for taking a 1% early payment discount for settlement within 14 days can now be calculated as follows
Effective interest rate = (1 + i / m )m - 1 i = 23.04% m = 365 / 16 = 22.81 Effective interest rate = (1 + 23.04% / 22.81 )22.81 - 1 Effective interest rate = 25.8%
Cost of Trade Credit Formula
By rearranging the effective interest rate formula above, we can arrive at the cost of credit formula to give the cost in terms of the known parameters of early payment discount, normal supplier credit term days, and discount term days as follows:
d = Early payment discount percentage
Days = Normal term days – Discount term days
Using this formula we get the same answer as follows:
Cost of trade credit = (1 + (d / (1 - d))(365 / Days) - 1 d = 1% Days = 30-14 = 16 Cost of trade credit = (1 + 1%/(1-1%)) (365 / 16) - 1 Cost of trade credit = 25.8%
To avoid having to carry out this calculation, the table below summarizes the cost of trade credit for typical discount percentages and days. In this table the days value refers to the additional days the funds are available by not taking the early payment discount which is the difference between the normal credit term days and the discount days.
So in the example above, the terms were 1/14 net 30, which means that a 1% discount is offered for paying 16 days (30-14) early. Using the table above the 1% for 16 days early gives an cost of trade credit of 25.8% as calculated above.
Using another example, if the terms were 2/60 net 90, meaning a 2% discount is given for payment within 60 days with normal terms of 90 days, then the invoices are paid 30 days early (90 – 60), and from the table 2% for 30 days is an cost of trade credit of 27.9%.
To summarize, in this example the business is offered 1/14 net 30 terms from suppliers, the effect of this early payment discount is to reduce the days payable outstanding from 30 days to 14 days resulting in an increased working capital and funding requirement.
If the business does not take the early payment discount is has the cash (4,950) available for an extra 16 days and does not need to borrow from other sources. However, the cost of not taking the 1% early payment discount repetitively throughout the year results in an effective annual cost of trade credit of 25.8%.
It is not difficult to see that if the business could borrow at a rate which is less than the annualized cost of trade credit (25.8%), then it would be preferable to do so and take the early payment discount offered by the supplier.
While it is not always feasible for a business to borrow to finance working capital requirements, in the absence of other factors, careful consideration to the cost of trade credit should be given before giving up the right to take the early payment discount from the supplier.