The Treasurer’s Guide to Trade Finance

Common calculations

Interest rate calculations

Calculating the cost of funds is an important

element in managing working capital.

Treasurers often have a number of alternative

sources of finance to choose from when

selecting the most appropriate funding mix,

whether for the company as a whole or for a

specific project.

When comparing alternative scenarios,

it is always important to ensure that like is

compared with like.

Simple interest

The most straightforward finance

arrangements are based on simple interest.

This means the company will borrow a

principal sum and then repay the principal

plus a balloon interest payment at the end of

the term.

The repayment amount can be calculated

using the following formula:

repayment amount = [principal × (1 + r)]

where r is the rate of interest. So, for example,

if a company needs to borrow EUR 10 million

for one year at a rate of 3.5%, it will have to

repay the principal plus an interest payment

at the end of the year. This is calculated as

[10,000,000 × (1 + 0.035)], which equals

EUR 10.35 million.

Calculating the cost of a discount

It is common for finance to be arranged at a

discount. For example, banks and factoring

companies are prepared to discount an

invoice as a means of providing funding.

Suppliers may also offer a discount for early

payment. In both cases it is important that

the company can calculate the true value of

the discount to ensure the most appropriate

decision is taken.

The following formula translates a future

cash flow into a present value:

PV = FV / (1 + r/n)d/y

where r is the rate of interest, n is the

number of interest payments every year,

d is the number of days until the cash flow

and y is the number of days in the year (as

determined by the day-count convention).

In most cases the treasurer will be

evaluating the cost of a discount for less than

a year, so it is appropriate to calculate the

annualised rate of interest for comparison

purposes. As a result, the appropriate formula

will be:

FV/PV = (1 + r)d/y

Knowing the future value (the face value of

the invoice), the present value (the level of

funds the financier is prepared to advance)

and the time frame between the two, the

treasurer can calculate the effective interest

rate charged on the advanced funds, by

rearranging the above formula:

r = [(FV/PV)y/d] – 1

For example, a bank is prepared to offer

GBP 1.19 million cash in five days’ time on

the strength of an invoice with a value of

GBP 1.2 million due to be paid in 60 days.

Using the formula above, the calculation

for the interest rate is as follows:

r = [(1,200,000/1,190,000)365/60] – 1

So r = 0.0522 or 5.22%.

This applies equally when the company is

offered early payment terms by one of its

suppliers. The company should factor in

the benefit of the discount as well as any

additional cost of funds that will be needed to

meet the early payment deadline.