Cashing in on credit.
Many businesses purchase inventory/goods from their vendors on trade credit. Trade credit is an open line of credit that vendors provide to their clients on an approved basis. Businesses can use their trade line up to their approved limit and pay back the funds based upon the agreed terms.
The terms vary depending on industry and situation, but generally it is 30 days (possibly longer when dealing with Mainland vendors, to accommodate for additional shipping time). The borrowed funds are interest-free and at times the vendor may also offer a trade discount for paying early. Cash discounts are offered as an inducement for prompt payment and can be communicated in terms that read "2/10 net 30." This simply means that if the business pays the vendor within 10 days, a discount of 2 percent can be taken; if not, the net balance is due within 30 days.
Vendors establish trade credit facilities in an effort to increase their revenues by inducing businesses to buy from them. Businesses should always take advantage of trade discounts, provided they have the cash or access to cash (like a bank revolving line of credit), and as long as the cost does not outweigh the benefit of the savings.
Of course, it would be simple to demonstrate the cost savings given the scenario where a business has sufficient cash reserves to take advantage of the early-pay discount. However, determining whether it is beneficial for a business to utilize its bank revolving line of credit to take advantage of trade discounts is a little trickier. Let's take a look at a scenario to determine whether taking trade discounts in conjunction with a bank revolving line of credit can help a business run more cost effectively.
Let's start by asking questions about the vendor's trade credit line:
* What are the terms of the trade credit?
* Is there a discount? If so, how much?
* How much are your purchases per month? Per year?
Of course, the answers you get here are specific to your business and your vendor relationships; however, let's assume your business has a trade credit line with the terms of 2/10, net 30, and purchases of $50,000 per month. To determine whether or not it is feasible for your business to borrow bank money and take the discount, you need to: 1) compute how much of a savings (monthly or annually) can be realized by taking the discount, and 2) compute how much it will cost to borrow the funds via a bank revolving line of credit.
How much will your business save by utilizing the trade discount?
With monthly purchases of $50,000 and utilizing a 2 percent early-pay discount, your business will save $1,000 per month or $12,000 annually ($50,000 X 2% = $1,000 per month. Annualized: $1,000 per month X 12 months = $12,000 per year).
How much will it cost your business to borrow the money via your bank revolving line of credit?
If our business borrows $50,000 per month at a rate of the Wall Street Journal's prime pate (6.75 percent at the time of this writing) + 3.0 percent or 9.75 percent, and assuming your business cash conversion cycle is 30 days (meaning the cash that you use to buy inventory/goods is convened back to cash revenues within 30 days), then your business will pay approximately $406 per month or $4,875 per year in interest.
Therefore, in this scenario, the annual net savings is the trade discount savings minus the cost of borrowing the money:
$12,000-$4,875 = $7,125 savings per year
Of course, we have not included all variables, such as the cost of setting up your bank line of credit, interest expenses, opportunity costs, interest-rate changes and unexpected situations like your accounts payable person being out on extended vacation. However, I think it is clear that, for a business looking for ways to save money, reduce expenses or ultimately improve cash flow through more profitable operations, trade credit is a good place to start.
KEVIN KAJI, VICE PRESIDENT AND MANAGER
WAIAKAMILO BUSINESS BANKING CENTER
BANK OF HAWAII