The cost of using supplier credit

- Economists tell us that there is no such thing as a free lunch. So let's compute the cost of using free supplier credit, both in terms of increased purchase cost and the opportunity cost of missed cash discounts. Let's consider a hypothetical buyer company with an average inventory balance of $1000. To keep things simple, let's say the buyer company supplier, Maker Company, produce that inventory out of raw materials, labor and overhead costing the same $1,000. Now, yes, I realize that this leaves the supplier with no profit, but we're keeping the example simple. If Maker Company has to pay cash of $1000 for the inventory production inputs, then Maker Company can either get that $1,000 from Buyer Company, or get it from external financing such as a bank. And if Maker Company grants free supplier credit to Buyer Company, then Maker Company has to get a bank loan and bank loans aren't free. The interest cost on those bank loans has to be paid by somebody. If this interest cost is built into the purchase price paid by Buyer Company, then Buyer pays all the financing cost. Now maybe a fair way to do this would be for Buyer and Maker to share the financing cost. Well, that's the purpose of cash discounts. Cash discounts are price reductions offered to customers who purchase inventory on account and who pay their bill early. The supplier/seller benefits because prompt payment decreases both the probability of bad debts and the need for outside short-term financing. A common cash discount is 2/10 net 30, which means a 2% discount is allowed if payment is made within 10 days of the invoice date. If the cash discount is not taken, the full invoice amount is due within 30 days of the invoice date. Now to illustrate, assume that Buyer made a $1,000 purchase on account and that the terms of the sale are 2/10 net 30. Buyer's payment options are illustrated in this diagram. In this situation, Buyer has two choices, pay $980 on day 10 after the credit purchase or $1,000 on day 30. The decision by a credit customer, whether to pay a early and take the cash discount can be analyzed as follows. I owe $980 on day 10. I can keep this $980 for an extra 20 days, but it will cost me $20. In essence, the supplier/seller offering the cash discount is extending a $980 loan for 20 days at an interest cost of $20. The effective annual interest rate on this loan is computed like this. There's the 20-day interest cost multiplied by the number of 20 day periods in a 365 day year. So the annual interest cost is $20 divided by $980 multiplied by 365 divided by 20. So that's 2.04% multiplied by 18.25 periods in a year. That's equal to 37.2%. That's the annual interest rate. So the buyer must aside if having use of the $980 for those additional 20 days is worth paying an effective annual interest rate of 37.2%. Now the answer's probably no. Even if the credit customer is strapped for cash, it would make more sense to go to a bank and borrow $980 on a short-term loan at an interest rate almost surely lower, much lower than 37.2%, in order to pay the account early and get the cash discount. Obviously, the lower the cash discount percentage, the lower the effective annual interest rate of missing the cash discount. If the terms were 1/10 net 30, that's a 1% discount allowed if the invoice is paid in 10 days, the annual interest rate would be 18.6%. However, because most firms can borrow funds at less than 18.6%, they would benefit by taking the discount, even if they had to borrow the funds from a bank to do so. The point, somebody has to pay the financing cost associated with obtaining this $1,000 inventory asset. This financing cost can be added to the price that Buyer pays for the inventory or the financing cost can be shared to the offering of cash discounts for the buyer to pay the maker more quickly.