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(^352) Financial Management
In reality, in many lines of business, smaller companies are ìcarriedî by their suppliers.
Trade credit as a source of funds
Since buyers generally do not pay for goods until some time after they are delivered,
trade credit is a short-term source of business funds. If a firm ìautomaticallyî pays all
its bills a certain number of days after the invoice date becomes a built-in source of
financing that varies with the production cycle. As the firm increases its level of
production, and thus its purchases, accounts payable increase commensurately providing
some of the funds needed to finance the increase in production. Similarly, as production
decreases, purchases, and thus account payable, decrease.
Although change in the size of a firmís account payable may not be able to move with
inventory adjustments, there will ordinarily be a strong degree of correspondence between
the two. If a firm adheres strictly to the practice of always paying its bills a certain
number of days after invoice date, trade credit cannot be considered a discretionary
source of financing.
Instead, it becomes determinate insofar as it is dependent on the purchasing plan of the
firm which, as we discussed earlier, is dictated largely by its production cycle. Although
prompt payment of such obligations is generally to be commended, certain advantages
may be gained from using trade credit as a discretionary source of short-term financing.
When the company gets the trade credit, it would like to pay back as late as possible,
because these are the funds that require no interest payments and are free of cost.
Right. Wrong, these funds are not free of cost because the sale price of these already
includes the cost of the time for which the credit is given.
Cost of Trade Credit
For purposes of measuring the true cost, or the effective annual rate of interest associated
with use of trade credit as a discretionary source of short-term business funds, it is
necessary to consider the effects of its use both when :
(1) a company fails to take its cash discounts but nevertheless pays within the net
period, and
(2) a company fails to take its discounts and allows its payable to become overdue.
These two situations are the only ones that involve an actual cost to the debtor. If no
cash discount is offered, then there is no cost for the use of credit during the ìnetî
period, however long it may be. By the same token, if a discount is available and the
buyer takes it, there is also no cost for the use of credit during the discount period.
However, if a cash discount is offered and is not taken, there is an explicit opportunity
cost for the use of third credit.