Trade credit from suppliers provides businesses of all sizes a simple yet effective form of short-term commercial financing to help free up your cash flow and increase your purchasing power. Since the supplier is financing the purchase, supplier trade credit is essentially an interest-free loan for the buyers. 

Supplier trade credit circumvents traditional lending methods that typically require extensive documentations and credit history that startups simply do not have. Often the raw cost of the supplier trade credit to the business utilizing the credit is $0 if paid within the standard payment terms of previously-agreed upon 30, 60, 90, or 120 net day period.  This 0% financing is often recorded via accounts payable and can boost a company’s assets while postponing cash payment until some predetermined time in the future. 

Oftentimes, suppliers also offer discounts on this short-term financing that banks and traditional lenders simply do not even consider. The supplier trade credit allows for a cash discount or an early payment discount, by paying the full invoiced amount by a date that is well before the listed invoice due date. Often this early payment discount will only be in effect for 10 or 15 days, on a net 30 or longer invoice.

For example, if a supplier offers trade credit with payment terms of “2%/10 net 60” or simply just “2/10 net 60”, it means the customer is given 60 days from the invoice date to pay the supplier in full. Additionally, an early payment discount of 3% is given off of the stated price if full payment is made within 10 days of invoicing. These early payment discount terms are typically written out as “Early Payment Discount” amount or as a percentage in savings. Depending on your primary objective, we can utilize the calculation of the cost of trade credit to determine whether or not you should pay the early payment discount through your working capital lender.

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Calculating the Cost of Trade Credit Examples

If your business receives an invoice from the supplier for an amount of $5,000 with payment terms of 2/10 net 60, the early payment discount would come out to $100. This means the total invoice amount would come down to $4,900 if the invoice is paid within 10 days. Another way of looking at this situation is by considering the cost of having that $4,900 for an additional 50 days by paying the full invoice amount at the end of the trade credit period. We can also express this cost as an interest rate making it easier to compare utilizing the full trade credit period with taking out a more traditional loan.

The Nominal Cost of Trade Credit

First, we calculate the nominal cost of trade credit for not taking the stated discount using the following formula:

Nominal Cost of Trade Credit  = Discount / (1 - Discount) x (365 / (Term Days - Discount Days))

Discount = early repayment discount percentage
Discount Days = early payment discount days
Term Days = Total allowed payment days

So, using our example we get the annualized interest rate charged:

Nominal Cost of Trade Credit =   2% / (1 - 2.0%) x (365 / (60 - 10))

= 14.9%

The Effective Cost of Trade Credit

The nominal cost of trade credit above is the annualized rate based on not taking the early repayment discount for this period.  If your business does not take the early repayment discount continually throughout the year, then you should use the effective cost of trade credit formula to capture the compounding periods.  Now, we want to turn this nominal cost of trade credit into an effective annual rate (EAR) using the following formula:

Effective Annual Rate (EAR) = (1 + i / n) ^ n - 1

i = nominal annual interest rate
n = number of compounding periods

We can determine the number of compounding periods in a year by simply dividing 365 days by the number of extra days cash is retained for. For our example this comes out to 365 / 16 = 22.8. Now, we can solve for the EAR.

Effective Cost of Trade Credit = (1 + 14.9% / 7.3) ^ 7.3 - 1

         = 15.9%

Now, you must be thinking there must be a straightforward formula for calculating these costs without taking these steps every time you receive new terms for trade credit.

Cost of Trade Credit After Early Payment Discount Period Formula

The formula for the cost of trade credit along the invoicing duration is given as:

Cost of Trade Credit = ((1 + (Discount / (1 - Discount))) ^ (365 / (Term Days - Discount Days))) - 1

Discount = early repayment discount percentage
Discount Days = early payment discount days
Term Days = Total allowed payment days

So, with out example from above, we get:

Cost of Trade Credit = ((1 + (2% / (1 - 2%))) ^ (365 / (60 - 10))) - 1

= 15.9%

This means that during the discount period, there is zero cost to the financed funds, so it is in the best interest of the company to pay by the end of the discount period. After the initial discount period expires, the buyer begins with the highest cost of credit immediately following the expiration, which then decreases steadily until the final due date is reached and the cost of credit reaches a plateau.

Should You Take the Early Payment Discount?

Now that you understand how to calculate the effective annual rate of trade credit for your early payment discount, you can easily determine whether or not the early payment discount is worth it for you. It all comes down to which effective annual rate is lower, your early payment discount effective rate or your borrowing rate for working capital from your traditional credit provider. If your borrowing rate for working capital from your traditional credit provider is lower than the effective annual rate of your early payment discount, it is less expensive to simply borrow the funds needed to pay the invoice by the early payment period. However, if your rate for working capital is higher, utilizing the full term of your trade credit and sacrificing the early payment discount will be less expensive.

Using our example from above, if your borrowing rate for working capital is higher than 15.9% effective annual cost of trade credit, then you should utilize the full term of your trade credit. If your borrowing rate for working capital is lower than 15.9%, then it becomes less expensive to borrow the funds and pay off the invoice within the early payment period.  The decision is based on the assumption that your business has sufficient cash balances or access to available lines of credit.  However, if your business is operating on a limited cash balance or has difficulty borrowing more funds, then it might be better to utilize the allowable time until payment due dates.

What are the Most Common Payment Terms for Using Trade Credit?

Trade credit is most frequently offered in short-term and manageable payment term time frames such as 7, 15, 30, 60, and 90 days. These standard payment terms typically vary by industry and from country to country.

Food Industry Payment Terms

Typically, the food industry has one of the shortest standard payment terms of just a few days due to the perishable nature of the products. 

Construction Industry Payment Terms

Meanwhile, the construction industry regularly utilizes standard payment terms of 90 days and sometimes as long as 120 days due to required collection of lien waivers before the release of payments.

Professional Services Industry Payment Terms

The professional services industry payment terms vary fairly dramatically depending on the size and location of the firm with an average of approximately 74 days.

These terms are all laid out in the agreement and they mention the period for which credit is extended to the buyer, as well as any cash discount available and the type of credit being used.

How to Best Utilize Supplier Trade Credit for Your Small Business

Businesses with a free cash flow amount that would facilitate early payments should take advantage of supplier trade credit. You can utilize this short-term commercial financing to rake in hefty cash discounts if regularly paid early.

This could also apply to businesses that, while not swimming in cash, may have a fast turnaround from supply through manufacture and sale. If you only need trade credit for fabric, for example, and your facilities can take that fabric and create salable items in only a few days then those products can be sold quickly. While you may not be able to take advantage of frequent cash discounts, you may be able to use the supplier credit as effective short-term financing, relieving the burden of having to pay cash in advance for any materials or components you may need for your end product.

If you have a long manufacturing period, low cash flow, or require terms longer than net 90 or net 120, then you may be better suited to look for financing through a bank or credit union. The rates for short and long term lending from institutions like these are generally far more favorable than the supplier trade credit alternative.

When used properly, supplier trade credit becomes a great way to free up your cash flow. You can take advantage of early payment discounts which become particularly attractive to companies with short turnaround times from receiving goods to making sales. While banks and credit unions almost always beat trade credit for long-term financing, trade credit has serious advantages for regular short-term commercial financing.