Foundations of Financial Management: An Analysis (part 22)

“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” – Robert Kiyosaki

 Sources of Short-Term Financing

 by

 Charles Lamson

Trade Credit

The largest provider of short-term credit is usually at the firm's doorstep---the manufacturer or other seller of goods and services. Approximately 40 percent of short-term financing is in the form of accounts payable or trade credit. Accounts payable is a spontaneous source of funds, growing as the business expands on a seasonal or long-term basis and contracting in like fashion when business declines.

Payment Period

Trade credit is usually extended for 30 to 60 days. Many firms accept to "stretch the payment" to receive additional short-term financing. This is an acceptable form of financing as long as it is not carried to an abusive extent. Going from a 30- to a 35-day average payment period may be tolerated within the trade, while stretching payments to 65 days might alienate suppliers and cause a diminishing credit rating. A major variable in determining the payment period is the possible existence of a cash discount.

Cash Discount Policy

A cash discount allows a reduction in price if payment is made within a specified time period. A 2/10, net 30 cash discount means we can deduct 2% if we remit our funds 10 days after billing, but failing this, we must pay the full amount by the 30th day.

On a $100 billing, we could pay $98 up to the 10th day or $100 at the end of 30 days. If we fail to take the cash discount, we will get to use $98 for 20 more days at a $2 fee. The cost is a high 36.72%. Note that we first consider the interest cost and then convert this to an annual basis. The standard formula for this example is:

Cash discount terms may vary. For example on a 2/10, net 90 basis, it would cost us only 9.18% not to take the discount and to pay the full amount after 90 days.

In each case, we must ask ourselves whether bypassing the discount and using the money for a longer period is the cheapest means of financing. In the first example, with a cost of 36.72 percent, it probably is not. We would be better off borrowing $98 for 28 days at some lesser rate. For example, at 10 percent interest we would pay $0.54 in interest as opposed to $2 under the cash discount policy. With the 2/10, net 90 arrangement, the cost of missing the discount is only 9.18 percent and we may choose to let our suppliers carry us for an extra 80 days.

Net Credit Position

Accounts receivable is a use of funds and accounts payable on a source of funds. The firm should closely watch the relationship between the two to determine its net trade credit position. Net trade credit is positive when accounts receivable are greater than accounts payable and vice versa. If a firm has average daily sales of $5,000 and collects in 30 days, the accounts receivable balance will be $150,000. If this is associated with average daily purchases of $4,000 and a 25-day average payment, the average accounts payable balance is $100,000---indicating $50,000 more in credit is extended than received. Changing this situation to an average payment period of 40 days increases the accounts payable to $160,000 ($4,000 X 40). Accounts payable now exceed accounts receivable by $10,000, thus leaving these funds for other needs. Larger firms tend to be net providers of trade credit (relatively high receivables), with smaller firms in the user position (relatively high payables). 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 211-212*

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