What is the formula for credit cost?

Unpacking the Hidden Cost of Trade Credit: A Formula for Clarity

Trade credit, often presented as a “free” loan from suppliers, is anything but. While convenient, accepting trade credit involves an implicit cost that businesses must carefully consider. This cost represents the opportunity cost of forgoing a supplier’s discount for the privilege of delayed payment. Understanding this cost is crucial for sound financial decision-making. This article breaks down the calculation of this hidden cost.

The cost of trade credit isn’t a simple interest rate. It’s a complex calculation influenced by several factors: the discount percentage offered, the payment terms stipulated by the supplier, and the time value of money. The formula to determine this cost isn’t standardized, but a common and effective approach involves calculating the effective annual interest rate (EAR).

Let’s illustrate this with an example. Suppose a supplier offers terms of 2/10, net 30. This means a 2% discount is available if payment is made within 10 days; otherwise, the full amount is due in 30 days.

To calculate the EAR, we’ll use the following approach:

1. Determine the discount period: This is the difference between the discount period and the net payment period. In our example, the discount period is 30 days – 10 days = 20 days.

2. Calculate the cost of not taking the discount: This is the percentage cost of forgoing the discount. If the discount is 2%, the cost of not taking it is 2%.

3. Determine the annualized interest rate: This is where we factor in the time value of money. We need to annualize the cost of foregoing the discount. To do this, we use the following formula:

EAR = [(1 + Discount Percentage / (1 – Discount Percentage))^ (365 / Discount Period)] – 1

In our example:

EAR = [(1 + 0.02 / (1 – 0.02))^ (365 / 20)] – 1

EAR = [(1.020408)^18.25] – 1

EAR ≈ 0.416 or 41.6%

This calculation reveals that forgoing the 2% discount on a 2/10, net 30 credit term is equivalent to paying an annual interest rate of approximately 41.6%. This is significantly higher than many other financing options.

Important Considerations:

• This calculation assumes a 365-day year. Adjustments may be necessary depending on the specific accounting convention used.
• The formula assumes consistent repayment. In reality, variations in payment timing can affect the actual cost.
• Other financing options should be considered. Before accepting trade credit, businesses should compare the EAR to the interest rates available through bank loans or other financing options.

In conclusion, while trade credit offers flexibility, it’s vital to understand its true cost. The formula presented provides a framework for calculating the effective annual interest rate, enabling businesses to make informed decisions about whether accepting trade credit aligns with their financial goals. Failing to consider this hidden cost can significantly impact profitability.