- Trade\ncredit satisfies the working capital financing needs of the business<\/li>
- Efficient\nmanagement of trade credit helps in attaining better profitability<\/li>
- Appropriate\nrelationship management with vendors strengthens the supply chain system of the\nentity, thus, enabling it to realise sustainable development<\/li><\/ul>\n\n\n\n
Costs of Taking Trade Credit<\/h2>\n\n\n\n
It is usually conceived by\npeople that the trade credit does not carry any cost. However, this is not true,\nand trade credit carries the following costs:<\/p>\n\n\n\n
- Price of discount<\/strong>: Most often, there is a discount on the purchasing price that the firm foregoes to undertake when it uses trade credit, owing to the fact that it can take advantage of the discount only if it pays immediately to the supplier. Such a turned-down discount can translate into a high implicit cost for the firm.<\/li><\/ul>\n\n\n\n
- Cost\nof managing<\/strong>:\nManagement of creditors is accompanied with administrative and accounting<\/a> costs\nthat would otherwise not have been incurred, in case a firm dispenses with\navailing of trade credit.<\/li><\/ul>\n\n\n\n
- Loss\nof goodwill<\/strong>:\nIf the credit terms are overstepped by the business firm, the suppliers may\ndiscriminate against delinquent customers, and consequentially, supplies may\nalso become short. As a result of this, the relative market<\/a> strength of the\nbusiness may fall while also impacting its goodwill adversely.<\/li><\/ul>\n\n\n\n
- Adherence\nto conditions<\/strong>:\nSometimes, most of the suppliers insist that for availing the credit facility\noffered by them, firms should ensure that the purchase order should be of\ncertain minimum size or even on a regular basis<\/a>. They refuse to offer goods on\ncredit unless these conditions are met.<\/li><\/ul>\n\n\n\n
Costs of not taking Trade Credit\/ Benefits of Trade Credit<\/h2>\n\n\n\n
Not only does trade credit\ncome with some implicit costs, but it offers many benefits to business firms\nalso. In fact, it is considered as one of the most effective sources of\nobtaining short-term finance by business entities. The benefits offered by\ntrade credit or the cost of not taking trade credit cover the following:<\/p>\n\n\n\n
- Interest-free<\/strong>: Trade credit is a type of interest-free loan; therefore, failure to avail this credit facility can require the business to bear an interest cost. This cost is further increased if the interest rates are higher.<\/li><\/ul>\n\n\n\n
- Get a competitive edge<\/strong>: Acquiring required\nquantities of goods on credit gives the business a competitive advantage over other\nfirms that may have to pay upfront. It allows the business to be more flexible,\nadaptable to market demands and seasonal variations, by giving a constant\nsupply of goods even when finances are not stable.<\/li><\/ul>\n\n\n\n
- Easy to arrange<\/strong>: A good credit history,\nregular payments, and the capabilities to meet supplier’s requirements\ntypically ease the process of obtaining trade credit from vendors. Trade credit\nis often regarded as a formal, quick-&-easy to use credit arrangement.<\/li><\/ul>\n\n\n\n
- Help start-up businesses to\nraise funds<\/strong>:\nTrade credit assists start-up firms to get their operations running as they are\nunable to raise funding or secure business loans, yet need inventory quickly.<\/li><\/ul>\n\n\n\n
Read, Also:<\/b> 8 Key Performance Metrics for Accounts Payable Processes<\/a><\/mark>.<\/p><\/div>\n\n\n\n
Consideration of Cost of Payables<\/h2>\n\n\n\n
It is extremely important to\nanalyse the benefits offered by the suppliers via credit extension on the one\nhand and the cost involved in taking the credit extension provided by suppliers\n(i.e., the cost of discount foregone) on the other hand. In simple words, a\nrisk-return trade-off has to be put into due consideration before accepting\ncredit offers or discount offers by suppliers. There has to be judicious use of\ntrade credit by a business in order to maximise its returns. <\/p>\n\n\n\n
Suppose a company has been offered credit terms from its major supplier of “2\/10, net 45”. The amount of the purchase invoice is Rs. 20,000<\/strong>. Hence, the company has the choice of paying Rs. 20,000 at 45<\/strong>th<\/strong><\/sup> day by accepting trade credit or else paying Rs. 19,600 at the 10th<\/sup> day by accepting the discount offer. With the first option, the company can invest Rs. 19,600 for an additional 35 days and eventually pay the supplier Rs. 20,000 at the end of 45 days. The decision as to whether the discount should be accepted or not depends on the opportunity cost of investing Rs. 19,600 for 35 days. The company can invest additional cash and can obtain an annual return of 25%. <\/p>\n\n\n\n
For analysing the cost of payables, the two alternatives, in this case, are as follows:<\/em><\/strong><\/p>\n\n\n\n
\n Particulars<\/strong>\n <\/td> \n Refuse\n discount and take credit (Rs.)<\/strong>\n <\/td> \n Accept\n discount and refuse credit (Rs.)<\/strong>\n <\/td><\/tr> \n Payment to suppliers \n <\/td> \n 20,000 (on 45th<\/sup> day)\n <\/td> \n 19,600 (on 10th<\/sup> day)\n <\/td><\/tr> \n Return generated from investing Rs. 19,600\n between day 10 and day 45 (Rs. 19,600 × 35\/365 × 25%)\n <\/td> \n (470)\n <\/td> \n –\n \n <\/td><\/tr> \n Net cost payable\n <\/td> \n 19,530\n <\/td> \n 19,600\n <\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n Thus, it is better for the\ncompany to refuse the discount, as return on cash retained is more than the\nsaving on account of the discount. Had the annual rate of return on investment\nbeen 20%, it would have been more favourable to accept the discount offer of\n2%. In that case, the net cost payable would have been Rs. 19,624.<\/p>\n\n\n\n
Another aspect to consider here is calculating the annualised cost of taking credit, i.e., the cost of not taking the discount and delaying the payment for a term of 35 days. Such annualised cost of trade credit<\/strong> is computed with the help of below formula:<\/p>\n\n\n\n
![\"cost](\"https:\/\/enterslice.com\/learning\/wp-content\/uploads\/2020\/04\/formula-1.png\")
<\/figure>\n\n\n\nThe company can compare its\ncost of funds or short-term investment rate with the cost of trade credit to\nmake a decision regarding availing the discount. Generally, in most cases, if\nthe cost of funds or short-term investment rate is lower than the cost of trade\ncredit, then the company will benefit by paying its invoices within the\ndiscount period.<\/p>\n\n\n\n
On the other hand, if the\nbusiness could borrow at a rate which is less than the annualised cost of trade\ncredit, then it would be preferable to do so and take the early payment\ndiscount offered by the supplier.<\/p>\n\n\n\n
In the example given above,\nthe cost of trade credit comes out to 23.45%, with discount% = 0.02 and Days\nafter discount period = 35. Thus, when the company delays suppliers’ payment,\nit incurs an annualized cost of 23.45% per annum. Now, let’s assume that the\ncompany can borrow a bank overdraft at an interest rate of 18% p.a.; here it\nwould be preferable for the company to borrow money from bank instead of\navailing the supplier’s credit. <\/p>\n\n\n\n
Role of the Finance Manager towards Management of Payables<\/h2>\n\n\n\n
Some of the techniques which\nmay be employed by the finance manager for effective management of accounts\npayables are:<\/p>\n\n\n\n
- Help start-up businesses to\nraise funds<\/strong>:\nTrade credit assists start-up firms to get their operations running as they are\nunable to raise funding or secure business loans, yet need inventory quickly.<\/li><\/ul>\n\n\n\n
- Easy to arrange<\/strong>: A good credit history,\nregular payments, and the capabilities to meet supplier’s requirements\ntypically ease the process of obtaining trade credit from vendors. Trade credit\nis often regarded as a formal, quick-&-easy to use credit arrangement.<\/li><\/ul>\n\n\n\n
- Get a competitive edge<\/strong>: Acquiring required\nquantities of goods on credit gives the business a competitive advantage over other\nfirms that may have to pay upfront. It allows the business to be more flexible,\nadaptable to market demands and seasonal variations, by giving a constant\nsupply of goods even when finances are not stable.<\/li><\/ul>\n\n\n\n
- Interest-free<\/strong>: Trade credit is a type of interest-free loan; therefore, failure to avail this credit facility can require the business to bear an interest cost. This cost is further increased if the interest rates are higher.<\/li><\/ul>\n\n\n\n
- Adherence\nto conditions<\/strong>:\nSometimes, most of the suppliers insist that for availing the credit facility\noffered by them, firms should ensure that the purchase order should be of\ncertain minimum size or even on a regular basis<\/a>. They refuse to offer goods on\ncredit unless these conditions are met.<\/li><\/ul>\n\n\n\n
- Loss\nof goodwill<\/strong>:\nIf the credit terms are overstepped by the business firm, the suppliers may\ndiscriminate against delinquent customers, and consequentially, supplies may\nalso become short. As a result of this, the relative market<\/a> strength of the\nbusiness may fall while also impacting its goodwill adversely.<\/li><\/ul>\n\n\n\n
- Cost\nof managing<\/strong>:\nManagement of creditors is accompanied with administrative and accounting<\/a> costs\nthat would otherwise not have been incurred, in case a firm dispenses with\navailing of trade credit.<\/li><\/ul>\n\n\n\n
- Price of discount<\/strong>: Most often, there is a discount on the purchasing price that the firm foregoes to undertake when it uses trade credit, owing to the fact that it can take advantage of the discount only if it pays immediately to the supplier. Such a turned-down discount can translate into a high implicit cost for the firm.<\/li><\/ul>\n\n\n\n