What Is Cost of Trade Credit (Accounts Payable)?

Definition

Cost of trade credit is the terms that suppliers offer businesses for trade credit. Trade credit is the amount businesses owe to their suppliers on inventory, products, and other goods necessary for business operation.

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Key Takeaways

  • Small businesses generally use trade credit, or accounts payable, as a source of financing
  • Trade credit is the amount businesses owe to their suppliers on inventory, products, and other goods
  • Trade credit creates an account payable on the books of the company. Its recorded as an accounts receivable on the books of the supplier
  • Suppliers may have a policy of offering discounts on payments to trusted business clients

How Trade Credit Works

Small businesses generally use trade credit, or accounts payable, as a source of financing. When a trustworthy company buys from a supplier, that supplier will often allow the company to delay payment.

Note

Trade credit creates an account payable on the books of the company while its recorded as an accounts receivable on the books of the supplier.

When the supplier allows delayed payment, they are effectively extending financing to the company they trust, and this credit becomes a source of working capital for the company to spend elsewhere. For small businesses and startups, trade credit may be the only financing available to the company; thus, suppliers know to keep a close eye on their accounts receivable, and on the companies that hold credit with them.

Pick Suppliers Carefully

When opening a business, you must pick suppliers not just for the physical products they can offer, but also for their performance record and their terms of trade credit.

Note

If you've opened a new business, you should aim to work with suppliers that offer room to grow with more favorable trade credit terms, achievable through consistency and trust-building efforts on your part.

When choosing suppliers, new clients will generally submit a proposal emphasizing how much inventory their business will currently need, as well as projections for how much they anticipate needing in the future. You should find evidence to demonstrate how your company is well suited to the supplier and a company worthy of trust and trade credit. The more business you do with a supplier, the better your negotiating position will be with regard to the terms of trade credit.

The Cost of Trade Credit

There are costs associated with having trade credit granted to your company by suppliers. Suppliers are generally in the same position you are regarding cash flow, so the effective cost of what you purchase from the suppliers is often higher than if you were paying cash. Not only do you have to absorb the higher purchase price, but you have to figure in the actual cost of trade credit.

Suppliers likely have a credit policy for their trusted customers. That credit policy may have terms of trade that look something like this: 2/10, net 30. This means that the supplier will offer you a 2% discount if you pay your bill in 10 days. If you don't take the discount, then the bill is due in 30 days. If you're offered these terms of trade by a supplier, what do they mean?

Calculating Cost of Trade

Below is a formula for calculating the cost of trade credit. You can also use this formula for calculating the cost if you don't take the trade discount. Let's say your company is offered terms of trade of 2/10, net 30 but is not able to take the 2% discount. In other words, you don't have the cash flow to pay the bill and receive the discount within 10 days, what is this going to cost you?

Here's the formula to calculate the cost of not taking the discount:

Discount Percentage ÷ (1-Discount %) x [360/(Full allowed payment days - Discount days)]

Here's the step-by-step explanation of the formula using the example given above: 2/10 net 30.

  1. Divide the discount percentage, 2%, by (100% - 2%), the difference of 100% minus the 2% discount percentage. It equals 2.0408% 
  2. Divide 360, nominal days in a year, by the sum of full allowed payment days (30 days) minus allowed discount days (10 days). It equals 18.
  3. Multiply the result of 2.0408% by 18. It equals 36.73%, the real annual interest rate charged.

According to the terms in our example above, 36.73% is the cost of not taking the discount. You could get a credit union or bank loan at a lower rate than that. 

Using Trade Credit

Should your company use trade credit to buy its inventory and supplies or another source of financing? If your company has the free cash flow to take the discount offered in the terms of credit, then yes. However, you should calculate the cost of trade credit, or the cost of not taking the discount, as in the section above.

If you don't have the cash flow to take the discount, you're usually better off with a cheaper form of financing. It's always better to have enough cash flow on hand to take the discount.

Frequently Asked Questions (FAQs)

What are the costs and benefits of trade credit?

For small businesses, trade credit is a source of financing and cash flow management. Discounts offered by suppliers may also benefit businesses by reducing their costs. However, there are costs associated with trade credit. The suppliers decide the payment schedule, and while discounts are provided, they are not applicable indefinitely. If you miss availing the discounted rate by making timely payments, the cost of not taking the discount to could add up over time.

What is the annualized cost of missing trade credit discount?

You can calculate the annualized cost of missing a trade credit discount using a simple formula. Your suppliers will typically let you know the discount percentage, the number of discounted days and total days till payment is due. Start by dividing the discount percentage by one minus the discount percentage. Divide 360 by days to payment minus the number of discount days. Multiply the two numbers calculated above.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Pepperdine University. "Free and Costly Trade Credit: A Comparison of Small Firms."

  2. Bureau of the Fiscal Service. "Formula and Calculator for Discounts."

  3. Daniel T Winkler. "The Cost of Trade Credit: A Net Present Value Perspective."

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