The costs of the additional trade credit from forgoing discounts under some other
purchase terms are shown below:As these figures show, the cost of not taking discounts can be substantial. Incidentally,
throughout the chapter, we assume that payments are made either on thelastdayfor tak-
ing discounts or on thelast dayof the credit period, unless otherwise noted. It would be
foolishtopay,say,onthe5thdayoronthe20thdayifthecredittermswere2/10,net30.^12
On the basis of the preceding discussion, trade credit can be divided into two com-
ponents: (1) free trade credit, which involves credit received during the discount pe-
riod, and (2) costly trade credit,which involves credit in excess of the free trade
credit and whose cost is an implicit one based on the forgone discounts. Firms should
always use the free component, but they should use the costly component only after analyzing
the cost of this capital to make sure that it is less than the cost of funds that could be obtained
from other sources. Under the terms of trade found in most industries, the costly com-
ponent is relatively expensive, so stronger firms will avoid using it.What are accruals? How much control do managers have over accruals?
What is trade credit?
What is the difference between free trade credit and costly trade credit?
How does the cost of costly trade credit generally compare with the cost of
short-term bank loans?Alternative Short-Term Financing Policies
Up until this point we have focused on the management of net operating working cap-
ital. We now turn our attention to decisions involving short-term investments and
short-term financing.
Most businesses experience seasonal and/or cyclical fluctuations. For example,
construction firms have peaks in the spring and summer, retailers peak around Christ-
mas, and the manufacturers who supply both construction companies and retailers fol-
low similar patterns. Similarly, virtually all businesses must build up net operating
working capital (NOWC) when the economy is strong, but they then sell off invento-
ries and reduce receivables when the economy slacks off. Still, NOWC rarely drops toCost of Additional Credit if the
Cash Discount Is Not Taken
Credit Terms Nominal Cost Effective Cost
1/10, net 20 36.9% 44.3%
1/10, net 30 18.4 20.1
2/10, net 20 74. 5109.0
3/15, net 45 37.6 44.9(^12) A financial calculator can also be used to determine the cost of trade credit. If the terms of credit are 2/10,
net 30, this implies that for every $100 of goods purchased at the full list price, the customer has the choice
of paying the full amount in 30 days or else paying $98 in 10 days. If a customer decides not to take the
discount, then it is in effect borrowing $98, the amount it would otherwise have to pay, from Day 11 to Day
30, or for 20 days. It will then have to pay $100, which is the $98 loan plus a $2 financing charge, at the end
of the 20-day loan period. To calculate the interest rate, enter N 1, PV 98, PMT 0, FV 100, and
then press I to obtain 2.04 percent. This is the rate for 20 days. To calculate the effective annual interest rate
on a 365-day basis, enter N 20/365 0.05479, PV 98, PMT 0, FV 100, and then press I to
obtain 44.6 percent. The 20/365 0.05479, is the fraction of a year the “loan” is outstanding, and the
44.6 percent is the annualized cost of not taking discounts.
Alternative Short-Term Financing Policies 603