Working Capital Financing^353
For example, the Road Company purchases it raw materials on terms of 2/10 net 30. It
thus has the option of using the funds for 20 days after the discount period if it ìpassesî
the discount but pays on the final day of the net period. Road Co., however, must pay 2
% of the privilege of using the funds for 20 days. It is given by the equation:
R = C(365 D)
D (100-C)
where
C = the cash discount
D = the number of extra days Road has the use of the
supplierís fundsR = the annual interest rate for the use of these funds
In our example, C = 2 percent, D = 20: the effective annual interest rate for the
company would be
R = 2 (365) 37.24 per cent
20 (100-2)
Thus, we see that passed discounts can transform trade credit from a normally easy
sources of funds into a very expensive form of short-term financing. Therefore, if other
financing is available even though with high interest rates, say 20 or 24%, Roadís
financial administrator would be well advised to borrow in sufficient time so that it can
take advantage of any cash discounts offered by its suppliers.
Sometimes companies that are short of cash and lack reserve borrowing power may be
forced to not only pass up cash discounts but also postpone payment beyond the net
period. This practice is referred to as ìstretchingî accounts payable or ìridingî trade
creditors.
There are two types of costs incurred by a company that stretches its accounts payable
(1) the explicit cost of discounts foregone, as outlined above, and
(2) the implicit cost of permitting its trade credit rating to deteriorate.
If a company rides its creditors excessively, so that its trade payable become noticeably
delinquent, its credit rating among all suppliers in the trade will surely suffer. They will
view the company as increasingly risky to sell to and may quickly begin to impose
rather strict terms of sale, upto and including COD or CBD.
Proper Use of Trade Credit
As compared with other kinds of short-term business credit ó bank loans, for example-
trade credit is almost automatic. And because it may be much more readily acquired,