How to Compute Cost of Credit - Credit CostThe computation of the cost of credit—the cost of not taking credit terms extended for a business transaction, is an essential part of doing business. The cost of not taking trade credit (also known as “credit cost”) usually increases during relatively good economic periods—more generous discounts being offered. In contrast, however, the cost of not taking trade credit usually declines as the discount terms are reduced in periods of economic downturn. But, those common situations are not really happened during the 2007-2010 where we’ve been having brutal economic downturn. Trade credit can serve the dual purpose of financing purchases while using the funds to finance credit sales to customers. A controller would have to examine trade credit terms carefully.

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How Trade Credit Terms and Cost of Credit Are Applied

Credit terms usually express the amount of the cash discount, the date of its expiration, and the due date. A typical credit term is “2/10, net/30”. It means if payment is made within 10 days, a 2 percent cash discount is allowed; otherwise, the entire amount is due in 30 days. The cost of not taking the cash discount can be substantial.

The acceptance of trade credit is a normal part of doing business and is considered a spontaneous source of financing since it normally expands as the volume of business increases. It is not unusual for a manufacturer to ship merchandise and wait a specified period of time for payment. Often trade credit is extended to a business that is not qualified to obtain bank financing.

 

How Is Cost of Credit (Credit Cost) Computed?

The formula for computing the cost of credit if a cash discount is not taken is:

Credit Cost = [Percent Discount / (100 – Percent of Discount)] x [360 / (credit period – discount period)

 

Case Example of Credit Cost (Cost of Credit) Calculation

Suppose that Lie Dharma Company has extended $900 of trade credit to a customer on terms of ”2/10, net/30.” The customer can either pay $900 × 98% = $882 at the end of the 10 day discount period, or wait for the full 30 days and pay the full $900. By waiting the full 30 days, the customer effectively borrows $882 for an additional 20 days, paying $900 – $882 or $18 in interest.

With the above information, the credit cost of borrowing this money can be computed as follows:

Cost of Credit
= [Percent Discount/(100 – Percent of Discount)] x [360/(credit period – discount period)]
= [2/(100-2)] x [(360/(30-10)]
= 2/98 x 360/20
= 36.73%

As this example illustrates, the annual percentage cost of offering a “2/10, net/ 30” trade discount is almost 36.73%.

 

Annualizing The Credit Cost

The 20-day discount period occurs 18 times per year. Using this information, it is possible to compute the effective annual rate of interest on a 360-day year:

Effective Annual Credit Cost
= [1+ (credit cost/times compounded per year) degree “Times compounded per year – 1
= [1 + (86.73/18)] degree 18 – 1
= 48.85 percent

Annualized, the 36.73 percent cost of interest amounts to a substantial 48.85 percent.

Some examples of additional credit costs are illustrated below:
 
Credit terms
Discount  Days  Net  Percent  Annualized 
1              10       20   36.36%   43.59%
1              10       30   18.18%   19.88%
2              10       20   73.47%   106.96%
2              10       30   36.73%   44.12%
3              10       20   111.34%  199.38%
3              10       30   55.67%   73.75%

 

The cost of trade credit may be of secondary importance to some buyers when no other form of credit is available; however, when other credit is available, it may be worth doing some comparison shopping. Often, the buyer may be paying a hidden financing charge in terms of higher merchandise prices. At other times, trade credit may represent a virtual subsidy by a seller to a customer, e.g., by a manufacturer to a distributor, and it should be utilized.