firms: Because small companies often do not qualify for financing from other sources,
they rely especially heavily on trade credit.^10
Trade credit is a “spontaneous” source of financing in the sense that it arises from
ordinary business transactions. For example, suppose a firm makes average purchases
of $2,000 a day on terms of net 30, meaning that it must pay for goods 30 days after
the invoice date. On average, it will owe 30 times $2,000, or $60,000, to its suppliers.
If its sales, and consequently its purchases, were to double, then its accounts payable
would also double, to $120,000. So, simply by growing, the firm would spontaneously
generate an additional $60,000 of financing. Similarly, if the terms under which it
bought were extended from 30 to 40 days, its accounts payable would expand from
$60,000 to $80,000. Thus, lengthening the credit period, as well as expanding sales
and purchases, generates additional financing.The Cost of Trade Credit
Firms that sell on credit have a credit policy that includes certain terms of credit. For ex-
ample, Microchip Electronics sells on terms of 2/10, net 30, meaning that it gives its
customers a 2 percent discount if they pay within 10 days of the invoice date, but the
full invoice amount is due and payable within 30 days if the discount is not taken.
Note that the true price of Microchip’s products is the net price, or 0.98 times the
list price, because any customer can purchase an item at that price as long as the cus-
tomer pays within 10 days. Now consider Personal Computer Company (PCC),
which buys its memory chips from Microchip. One commonly used memory chip is
listed at $100, so the “true” price to PCC is $98. Now if PCC wants an additional
20 days of credit beyond the 10-day discount period, it must incur a finance charge of
$2 per chip for that credit. Thus, the $100 list price consists of two components:
List price $98 true price $2 finance charge.
The question PCC must ask before it turns down the discount to obtain the additional
20 days of credit from Microchip is this: Could we obtain credit under better terms
from some other lender, say, a bank? In other words, could 20 days of credit be ob-
tained for less than $2 per chip?
PCC buys an average of $11,923,333 of memory chips from Microchip each year
at the net, or true, price. This amounts to $11,923,333/365 $32,666.67 per day. For
simplicity, assume that Microchip is PCC’s only supplier. If PCC decides not to take
the additional trade credit — that is, if it pays on the 10th day and takes the discount—
its payables will average 10($32,666.67) $326,667. Thus, PCC will be receiving
$326,667 of credit from Microchip.
Now suppose PCC decides to take the additional 20 days credit and thus must pay
the finance charge. Since PCC will now pay on the 30th day, its accounts payable will
increase to 30($32,666.67)$980,000.^11 Microchip will now be supplying PCC with
an additional $980,000$326,667$653,333 of credit, which PCC could use to(^10) In a credit sale, the seller records the transaction as a receivable, the buyer as a payable. We examined ac-
counts receivable as an asset earlier in this chapter. Our focus now is on accounts payable, a liability item.
We might also note that if a firm’s accounts payable exceed its receivables, it is said to be receiving net trade
credit, whereas if its receivables exceed its payables, it is extending net trade credit. Smaller firms frequently re-
ceive net credit; larger firms generally extend it.
(^11) A question arises here: Should accounts payable reflect gross purchases or purchases net of discounts?
Generally accepted accounting principles permit either treatment if the difference is not material, but if the
discount is material, then the transaction must be recorded net of discounts, or at “true” prices. Then, the
higher payment that results from not taking discounts is reported as an additional expense called “discounts
lost.” Thus, we show accounts payable net of discounts even if the company does not expect to take discounts.
Accruals and Accounts Payable (Trade Credit) 601