Trade Credit

Discount terms split the payment period into two prices for the same goods: a lower price for early settlement and a higher price for delay. The cost of taking the delay is the discount forgone, expressed as a percentage of the amount that would actually have been paid early. In words, divide the discount rate by one minus the discount rate to get the periodic cost, add one, raise that figure to the power of 365 divided by the number of extra days gained, then subtract one. The result is an effective annual rate.

Two drivers matter. A larger discount raises the periodic cost, and a shorter extension period compresses that cost into fewer days, which magnifies the annualised figure. This is why terms offering a modest discount over a long net period can be cheap to forgo, while a similar discount over a short window is punitive. Terms with no discount carry no explicit price, but the delay is still valuable and the supplier has priced it into the invoice.

Trade credit accumulates as accounts payable, a non-interest-bearing current liability, and the offsetting cash retained never appears as borrowing. Because of this, heavy reliance on suppliers can leave leverage ratios built on debt look understated while liquidity ratios such as the current ratio deteriorate.

The activity measure is days payable outstanding, computed as payables divided by purchases or cost of goods sold and scaled to a year. Longer days payable shortens the cash conversion cycle, since that cycle equals days of inventory plus days of receivables minus days of payables. A firm that finances inventory entirely on supplier terms can operate with a negative cycle, collecting from customers before paying suppliers. Analysts watch abrupt increases in days payable, which may signal deliberate negotiation, deteriorating liquidity, or reclassification of payables into supply-chain finance arrangements.

Trade credit expands automatically with purchasing volume, which makes it the default first source of working capital for growing firms and for companies with limited access to bank lines or commercial paper. Its availability depends on the supplier's own credit assessment, the concentration of the relationship, and the buyer's bargaining power. Large buyers routinely dictate terms to smaller vendors.

Stretching payables beyond agreed terms is a distinct decision from forgoing a discount. It preserves cash but erodes trade references, invites tighter terms, price increases, priority loss in constrained supply, or cash-in-advance demands. Reverse factoring lets a bank pay suppliers early against the buyer's credit while the buyer settles later; the economics resemble borrowing even when the balance appears within payables. Disclosure of such programmes is now a focus for analysts precisely because it can mask financing.

Expect to be asked for the effective annual cost of forgoing a discount, sometimes alongside a nominal or simple annualised figure, so read whether compounding is required. Be careful with the denominator: the cost base is the discounted amount paid, not the gross invoice. Also confirm the number of days actually gained, which is the net period minus the discount period, not the full net period.

The decision rule is comparative. If the effective annual cost of stretching to the net date exceeds the firm's marginal short-term borrowing rate, including any commitment fees or compensating balances on a line of credit, the firm should draw on the line, pay early and capture the discount. If borrowing is dearer or unavailable, forgoing the discount is rational. Candidates should also be able to explain how a change in payment policy shifts days payable, the cash conversion cycle and reported operating cash flow.