Payables Management: Trade Credit, Discounts and Payment Timing
Course: Business Finance / Corporate Finance
Lecture: 7 – Payables Management
1. Learning Objectives
By the end of this lecture, students should be able to:
- Understand the nature of trade credit as a short‑term source of finance.
- Explain basic payables management strategies.
- Calculate and interpret the cost of trade credit when discounts are not taken.
2. Meaning of Accounts Payable
Accounts payable arise when a firm purchases goods or services on credit from its suppliers. Instead of paying cash immediately, the firm agrees to pay at a later date according to the supplier’s credit terms.
Until payment is made, the amount owed to suppliers is recorded as accounts payable, a current liability on the balance sheet. Effective payables management helps the firm use supplier credit as a financing source while maintaining good relationships with vendors. [web:61][web:64]
3. Trade Credit and Credit Terms
Trade credit is a short‑term financing arrangement in which suppliers allow buyers to purchase now and pay later. It is one of the most common sources of short‑term finance for businesses. [web:60][web:63]
Suppliers usually specify their terms using a standard notation. A widely used example is:
“2/10, net 30”
This means:
- The buyer can take a 2% discount on the invoice amount if payment is made within 10 days from the invoice date.
- If the buyer does not take the discount, the full amount is due within 30 days with no discount.
In other words, “2/10, net 30” offers the buyer a choice: pay early and cheap (with discount) or pay later and more (without discount). [web:55][web:58][web:59]
4. Advantages and Disadvantages of Trade Credit
4.1 Advantages of trade credit
From the buyer’s perspective, trade credit offers several important benefits:
- Easy financing: Trade credit is often easier to obtain than bank loans, especially for smaller firms, because it is built into the normal purchasing relationship.
- Flexible source of funds: The amount of trade credit naturally varies with purchase volume, providing financing that grows and shrinks with business activity.
- No immediate cash outflow: The firm can receive goods now and delay payment until the due date, helping to bridge timing gaps in its cash flow.
4.2 Disadvantages of trade credit
However, trade credit also has drawbacks and costs:
- Loss of cash discounts: If the firm does not pay early, it may lose attractive discounts such as 2% for paying within 10 days. The implicit cost of foregoing these discounts can be very high.
- Supplier pressure: Consistently paying late or ignoring credit terms can damage relationships, lead to stricter terms, or even loss of supply.
- Possible higher prices: Some suppliers may build the cost of credit into their list prices, so credit purchases may indirectly cost more than cash purchases.
Good payables management aims to make full use of trade credit benefits while avoiding excessive costs or strained vendor relationships. [web:60][web:61]
5. Cost of Not Taking Discount
When a supplier offers terms like “2/10, net 30”, choosing not to take the discount is effectively like borrowing money from the supplier at an implicit interest rate. We can estimate this rate as the cost of not taking the discount. [web:61][web:62]
A common formula to annualise this cost is:
Cost of not taking discount = (Discount % ÷ (1 − Discount %)) × (360 ÷ (Full allowed days − Discount period))
Where:
- Discount % = Percentage discount offered (e.g., 0.02 for 2%).
- Full allowed days = Final due date if discount is not taken (e.g., 30 days).
- Discount period = Number of days the discount is available (e.g., 10 days).
This formula shows the approximate annualised percentage cost of delaying payment from the end of the discount period to the final due date instead of paying early and taking the discount. [web:61][web:62]
6. Numerical Example – Annualized Cost of Delaying Payment
Example: A supplier offers credit terms of “2/10, net 30”. Your firm currently pays on day 30 and does not take the discount. What is the annualised cost of not taking the 2% discount?
Given:
- Discount % = 2% = 0.02
- Discount period = 10 days
- Full allowed days = 30 days
Step 1 – Calculate the periodic cost of not taking the discount:
Discount cost per period = 0.02 ÷ (1 − 0.02) = 0.02 ÷ 0.98 ≈ 0.0204 (2.04%)
Step 2 – Determine the number of such periods in a 360‑day year:
Number of periods per year = 360 ÷ (30 − 10) = 360 ÷ 20 = 18
Step 3 – Annualised cost of not taking the discount:
Annualised cost ≈ 0.0204 × 18 ≈ 0.3672 or 36.7%
Interpretation: By not taking the 2% discount and paying on day 30 instead of day 10, the firm is effectively “borrowing” at an implied rate of about 36.7% per year. Unless the firm’s alternative financing cost is even higher, it is usually better to take the discount when cash is available. [web:55][web:57][web:61]
7. Discussion Question – When Should a Firm Delay Payments?
Discussion prompt: When should a firm delay payments to its suppliers, and when should it pay early?
Points for class discussion:
- Delaying payment within the agreed credit period can help manage cash flow, but delaying beyond the due date may damage supplier relationships.
- If the supplier offers a discount (e.g., 2/10, net 30), the firm should compare the implicit cost of not taking the discount with its own cost of short‑term borrowing.
- The firm might deliberately delay payment when:
- There is no discount for early payment.
- The firm faces tight cash constraints and needs to conserve cash temporarily.
- Alternative financing is more expensive than the implicit cost of trade credit.
- However, chronic late payment can lead to:
- Stricter credit terms or shorter credit periods in future.
- Loss of priority with suppliers, especially in times of shortage.
- Damage to the firm’s reputation in the supplier community.
Overall, smart payables management balances the benefit of holding cash longer against the cost of lost discounts and the importance of strong supplier relationships. [web:61][web:64]
8. Homework – Lecture 7
Part A – Cost of not taking discount
- A supplier offers terms of “3/15, net 45”.
- Calculate the annualised cost of not taking the 3% discount if the firm pays on day 45.
- Briefly comment on whether it is likely to be rational to skip the discount if the firm can borrow at 14% per year.
Part B – Payables strategy reflection
- Choose a business you are familiar with (e.g., a retailer, wholesaler, or manufacturer) and describe how trade credit might be important for its operations.
- In 150–200 words, explain how this business should prioritise between:
- Taking early payment discounts, and
- Preserving cash by using the full credit period.
0 Comments