Understanding Trade Credit Costs

Okay, so in this video we're going to look at how to find the nominal annual cost of trade credit. So let's take a look at our problem. A coyote company regularly buys from its suppliers in the terms of 312 net 30 and pays within the discount period. If the coyote company wanted to increase its current liabilities by waiting longer to pay its suppliers, thereby foregoing the discounts, what would be the nominal annual cost of trade credit? assuming that the Coyote Company decided to pay on the 30th day? When would be the worst day for the Coyote Company to pay its suppliers if it was considering all of the possible days to pay? When would be the best possible day for the Coyote Company to pay its suppliers if it was considering all of the possible days to pay? So we have a few things that we're being asked to find here. First, what would be the nominal annual cost of trade credit assuming the Coyote Company decided to pay on the 30th day? Then... when would be the worst day, so the absolute worst day for the Coyote Company to pay its suppliers, and when would be the best possible day. So for this problem what we need is our equation for the nominal annual cost of trade credit. So our equation for the nominal annual cost of trade credit is the nominal annual cost is equal to the discount percentage divided by 100 minus the discount percentage and that whole amount times 365, the number of days in the year, divided by the days that the credit is outstanding, which I will abbreviate, minus the discount period. Okay, so in this particular problem, the terms specified are 312 net 30. So basically what that means is if we pay within the first 12 days, we get a 3% discount. Otherwise, if we pay after the 12 days, we pay the full price and we have to pay it within the 30 days. Now another way to look at this is that if I pay within the first 12 days, I actually pay a particular price. But if I pay after the 12 days, I incur a payout. penalty. So in other words, that's sort of the cost of giving up the discount. So we're going to look at this from the perspective of a penalty. In other words, I pay a lower price if I pay within the 12 days, and then if I pay after that, they hit me with a fine. So that's essentially what this part of the equation is doing over here, where I'm looking at the discount percentage relative to what I could have paid had I paid within the discount period and paid the lower price. hence the 100 minus the discount percentage. So if we fill in the pieces here, the nominal annual cost of trade credit is equal to 3, the discount percentage, over 100 minus the discount percentage, which is 3. And then what we have over here is essentially looking at a way of annualizing what I get for paying that penalty. So if I go past that 12th day, then I incur this penalty, And in exchange, I get a longer period of time to pay. So if we take 365 days in a year, and if we're looking at this first question, which is what would the nominal annual cost of trade credit be if we assume that the coyote company decided to pay on the 30th day. So if the coyote company pays on the 30th day, then it would be outstanding for 30 days. And the discount period, as we have established, is 12. So minus the discount period, which is 12. So if we look at this, what's happening here is if I take 30 minus 12, that means I've got an extra 18 days to pay by incurring this penalty that's reflected by this piece over here. Well 365 divided by the 18 tells us how many of those 18 day periods there are in a year. Now at this point, what you should do is you should pause the video and you should work out this first piece and see what you get. Okay. so if you pause the video and worked out this piece what you should have gotten is that the first chunk here is equal to 0.030928 so this means that the penalty is a little bit over 3% if we wait to pay until after the discount period so we're incurring a little bit more than a 3% penalty by waiting at this point you should pause the video and work out this piece right here Of course, making sure to follow the order of operations. Okay, so if you pause the video to work that out, what you should have found is that this portion in brackets works out to 20.2778. And that means that there are 20, or a little over 20, 18-day periods in a year. Because we got 18 extra days to pay when I went past that discount period and then had to pay within 30 days. And we indicated that we paid on the 30th day here, if we're the Coyote Company. So basically the Coyote Company is paying a penalty of a little over 3% and in exchange they're getting 18 days. And because most of the time when we compare interest rates, we compare on an annualized basis, it makes sense to find out how many 18-day periods there are in a year and that turns out to be a little over 20. So in effect, I'm paying a little over a 3% penalty per 18 days. So if I annualize that by multiplying by the number of 18-day periods there are in a year, I should find out what this works out to on an annual basis. So at this point, you should pause the video and work that out. Okay, so if you pause the video and work that out, what you should have gotten is 0.6272 or 62.72%. So that means that on an annualized basis, paying this penalty of a little over 3% in order to get that extra 18 days after the discount period is equivalent to borrowing at an annual rate of approximately 63% Obviously, this is not a particularly good deal However, we could also evaluate what this would look like if we paid at a different point in time So what if instead of paying on the 30th day we paid on the 20th day? Well if I paid on the 20th day If a Coyote company pays on the 20th day, then it's outstanding for 20 days So if the Coyote Company pays on the 20th day and it's outstanding for 20 days, then we'd have 20 minus 12 in the denominator here, which basically means the Coyote Company is procuring an extra 8 days of credit by incurring this penalty. Well, if you work that out, 365 divided by 8, you get a very different number. And I recommend you pause the video to work that out and see what you get. Okay, so if you pause the video to work that out, what you should have gotten is 45. 6 to 5. That means that there are approximately 46 eight-day periods within a year. So if we are the Coyote Company, and if we decide to pay on the 20th day, then we incur this penalty of a little over 3% for an eight-day period of time. And if we consider the fact there are approximately 46 eight-day periods in a year, on an annualized basis, you would take that little over 3% penalty times the 45.6 to find out what our annualized penalty is. So at this point you should pause the video and work that out and see what you get. Okay, so if you pause the video to work that out, what you should have gotten is 1.4111, or in other words, 141.11%. So that's obviously awful. And basically what that means then is if the Coyote company pays on the 20th day, they incur this penalty of approximately 3%, but they only got an extra 8 days for it. So if they only got an extra eight days for paying this penalty, on an annualized basis, paying a little over 3% every eight days works out to approximately 141%, which is awful. So if we compare these numbers, notice that they were incurring an annual rate of approximately 63% if they paid on the 30th day, but if they waited and paid on the 20th day, they're actually incurring an annualized rate of approximately 141%, which is even worse. So from that standpoint... Once the coyote company has missed the discount period, what they're going to want to do is actually get as many extra days as possible for the penalty that they're having to pay. So what that means then is if we're looking at the nominal annual cost, once the coyote company has missed the discount period to the 12 days, it makes sense for the coyote company to wait until the last possible day. to pay and that would mean that it would make sense if the Coyote Company is going to miss the discount period it makes sense for them to wait until the 30th day because that at least results in the lowest possible nominal annual cost once we've missed the discount period but that leads us to the next two questions which is when would be the worst day for the Coyote Company to pay its suppliers if it's considering all possible days Well, the answer to that is basically related to these calculations that we did right here. So notice that if we miss the discount and I wait to the 30th day, or if a company waits to the 30th day, they're paying approximately 63%. But if a company misses the discount and they wait to the 20th day, they're paying approximately 141% because they only got eight days this time. So what it turns out is the absolute worst possible day is going to be the day right after the discount period so in other words day 13. this is a terrible day for the coyote company to pay because if the coyote company pays on day 13 they waited just long enough to miss the discount but they only got one extra day for it so the absolute worst possible day for the coyote company to pay is day 13. it's a terrible day for them to be paying once a company has missed the discount window what it makes the most sense for them to do is to wait until the last possible day to pay because at least in that case they have gotten the most delay in their payment out of their penalty in other words they paid a penalty and they got the most they possibly could for it now with that in mind that leads to the next question which is what would be the best possible day for the coyote company to pay its suppliers so the best possible day is actually day 12. And the reason why the best possible day is day 12 is because of the fact that the Coyote Company gets this discount regardless of whether it pays on day 1, day 5, or day 12. So in other words, the Coyote Company pays the same lower price regardless of what day it pays as long as the payment goes through by day 12. So in that sense, the best day to pay is day 12 because the Coyote Company can still pay the lower price and delay payment until the 12th day, delaying the cash outflow and therefore allowing the Coyote Company to use its cash for an extra 12 days. And therefore, day 12 is the absolute best possible day for the Coyote Company to pay. At this point, I recommend that you try a few other problems and see how you do with this concept.

If the coyote company wanted to increase its current liabilities by waiting longer to pay its suppliers, thereby foregoing the discounts, what would be the nominal annual cost of trade credit? assuming that the Coyote Company decided to pay on the 30th day? When would be the worst day for the Coyote Company to pay its suppliers if it was considering all of the possible days to pay?

When would be the best possible day for the Coyote Company to pay its suppliers if it was considering all of the possible days to pay? So we have a few things that we're being asked to find here. First, what would be the nominal annual cost of trade credit assuming the Coyote Company decided to pay on the 30th day?

Then... when would be the worst day, so the absolute worst day for the Coyote Company to pay its suppliers, and when would be the best possible day. So for this problem what we need is our equation for the nominal annual cost of trade credit. So our equation for the nominal annual cost of trade credit is the nominal annual cost is equal to the discount percentage divided by 100 minus the discount percentage and that whole amount times 365, the number of days in the year, divided by the days that the credit is outstanding, which I will abbreviate, minus the discount period. Okay, so in this particular problem, the terms specified are 312 net 30. So basically what that means is if we pay within the first 12 days, we get a 3% discount.

Otherwise, if we pay after the 12 days, we pay the full price and we have to pay it within the 30 days. Now another way to look at this is that if I pay within the first 12 days, I actually pay a particular price. But if I pay after the 12 days, I incur a payout.

penalty. So in other words, that's sort of the cost of giving up the discount. So we're going to look at this from the perspective of a penalty.

In other words, I pay a lower price if I pay within the 12 days, and then if I pay after that, they hit me with a fine. So that's essentially what this part of the equation is doing over here, where I'm looking at the discount percentage relative to what I could have paid had I paid within the discount period and paid the lower price. hence the 100 minus the discount percentage.

So if we fill in the pieces here, the nominal annual cost of trade credit is equal to 3, the discount percentage, over 100 minus the discount percentage, which is 3. And then what we have over here is essentially looking at a way of annualizing what I get for paying that penalty. So if I go past that 12th day, then I incur this penalty, And in exchange, I get a longer period of time to pay. So if we take 365 days in a year, and if we're looking at this first question, which is what would the nominal annual cost of trade credit be if we assume that the coyote company decided to pay on the 30th day. So if the coyote company pays on the 30th day, then it would be outstanding for 30 days. And the discount period, as we have established, is 12. So minus the discount period, which is 12. So if we look at this, what's happening here is if I take 30 minus 12, that means I've got an extra 18 days to pay by incurring this penalty that's reflected by this piece over here.

Well 365 divided by the 18 tells us how many of those 18 day periods there are in a year. Now at this point, what you should do is you should pause the video and you should work out this first piece and see what you get. Okay.

so if you pause the video and worked out this piece what you should have gotten is that the first chunk here is equal to 0.030928 so this means that the penalty is a little bit over 3% if we wait to pay until after the discount period so we're incurring a little bit more than a 3% penalty by waiting at this point you should pause the video and work out this piece right here Of course, making sure to follow the order of operations. Okay, so if you pause the video to work that out, what you should have found is that this portion in brackets works out to 20.2778. And that means that there are 20, or a little over 20, 18-day periods in a year.

Because we got 18 extra days to pay when I went past that discount period and then had to pay within 30 days. And we indicated that we paid on the 30th day here, if we're the Coyote Company. So basically the Coyote Company is paying a penalty of a little over 3% and in exchange they're getting 18 days. And because most of the time when we compare interest rates, we compare on an annualized basis, it makes sense to find out how many 18-day periods there are in a year and that turns out to be a little over 20. So in effect, I'm paying a little over a 3% penalty per 18 days. So if I annualize that by multiplying by the number of 18-day periods there are in a year, I should find out what this works out to on an annual basis.

So at this point, you should pause the video and work that out. Okay, so if you pause the video and work that out, what you should have gotten is 0.6272 or 62.72%. So that means that on an annualized basis, paying this penalty of a little over 3% in order to get that extra 18 days after the discount period is equivalent to borrowing at an annual rate of approximately 63% Obviously, this is not a particularly good deal However, we could also evaluate what this would look like if we paid at a different point in time So what if instead of paying on the 30th day we paid on the 20th day? Well if I paid on the 20th day If a Coyote company pays on the 20th day, then it's outstanding for 20 days So if the Coyote Company pays on the 20th day and it's outstanding for 20 days, then we'd have 20 minus 12 in the denominator here, which basically means the Coyote Company is procuring an extra 8 days of credit by incurring this penalty. Well, if you work that out, 365 divided by 8, you get a very different number.

And I recommend you pause the video to work that out and see what you get. Okay, so if you pause the video to work that out, what you should have gotten is 45. 6 to 5. That means that there are approximately 46 eight-day periods within a year. So if we are the Coyote Company, and if we decide to pay on the 20th day, then we incur this penalty of a little over 3% for an eight-day period of time. And if we consider the fact there are approximately 46 eight-day periods in a year, on an annualized basis, you would take that little over 3% penalty times the 45.6 to find out what our annualized penalty is. So at this point you should pause the video and work that out and see what you get.

Okay, so if you pause the video to work that out, what you should have gotten is 1.4111, or in other words, 141.11%. So that's obviously awful. And basically what that means then is if the Coyote company pays on the 20th day, they incur this penalty of approximately 3%, but they only got an extra 8 days for it.

So if they only got an extra eight days for paying this penalty, on an annualized basis, paying a little over 3% every eight days works out to approximately 141%, which is awful. So if we compare these numbers, notice that they were incurring an annual rate of approximately 63% if they paid on the 30th day, but if they waited and paid on the 20th day, they're actually incurring an annualized rate of approximately 141%, which is even worse. So from that standpoint... Once the coyote company has missed the discount period, what they're going to want to do is actually get as many extra days as possible for the penalty that they're having to pay. So what that means then is if we're looking at the nominal annual cost, once the coyote company has missed the discount period to the 12 days, it makes sense for the coyote company to wait until the last possible day.

to pay and that would mean that it would make sense if the Coyote Company is going to miss the discount period it makes sense for them to wait until the 30th day because that at least results in the lowest possible nominal annual cost once we've missed the discount period but that leads us to the next two questions which is when would be the worst day for the Coyote Company to pay its suppliers if it's considering all possible days Well, the answer to that is basically related to these calculations that we did right here. So notice that if we miss the discount and I wait to the 30th day, or if a company waits to the 30th day, they're paying approximately 63%. But if a company misses the discount and they wait to the 20th day, they're paying approximately 141% because they only got eight days this time. So what it turns out is the absolute worst possible day is going to be the day right after the discount period so in other words day 13. this is a terrible day for the coyote company to pay because if the coyote company pays on day 13 they waited just long enough to miss the discount but they only got one extra day for it so the absolute worst possible day for the coyote company to pay is day 13. it's a terrible day for them to be paying once a company has missed the discount window what it makes the most sense for them to do is to wait until the last possible day to pay because at least in that case they have gotten the most delay in their payment out of their penalty in other words they paid a penalty and they got the most they possibly could for it now with that in mind that leads to the next question which is what would be the best possible day for the coyote company to pay its suppliers so the best possible day is actually day 12. And the reason why the best possible day is day 12 is because of the fact that the Coyote Company gets this discount regardless of whether it pays on day 1, day 5, or day 12. So in other words, the Coyote Company pays the same lower price regardless of what day it pays as long as the payment goes through by day 12. So in that sense, the best day to pay is day 12 because the Coyote Company can still pay the lower price and delay payment until the 12th day, delaying the cash outflow and therefore allowing the Coyote Company to use its cash for an extra 12 days. And therefore, day 12 is the absolute best possible day for the Coyote Company to pay.

At this point, I recommend that you try a few other problems and see how you do with this concept.

Transcript for:Understanding Trade Credit Costs

Transcript for:
Understanding Trade Credit Costs