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Using trade financing
Trade financing is the act of borrowing from suppliers and vendors to pay your bills. Just as you may extend trade credit to your customers to increase sales, your vendors will likely offer you trade credit.
Trade credit is often stated in such terms as "2/10 net 30" or "3/10 net 60." In the first case, your vendor offers a 2% discount of the invoiced amount if you pay within 10 days. If you don't take advantage of the discount, full payment is due within 30 days of the invoice. In the second case, your vendor offers a 3% discount if you pay within 10 days. Otherwise, payment is due in full within 60 days of the invoice.
Businesses often use trade credit to finance their purchases of inventory. Trade credit allows a company treasurer to hold on to cash for awhile longer. In exchange for holding onto your cash, you incur a liability called accounts payable. Some companies exploit trade credit, postponing payments for as long as the vendor tolerates. This practice is sometimes called "stretching accounts payable" or "riding the trade."
Stretching accounts payable can backfire as a strategy for improving cash flows. A company that chronically pays it vendors late earns a reputation as a late-payer, which may hinder the relationship. As a business owner, you should evaluate the trade-off in stretching accounts payable and alienating your vendors and suppliers that offer trade credit.
Stretching your accounts payable is the flip side of your customers not paying you on time. It's as if you were to be paid later than desired on your accounts receivable. As a result, you can evaluate your accounts payable performance using ratios that are similar to those used in evaluating accounts receivable. Two widely used financial ratios to analyze trends in your accounts-payable management are:
- Payables turnover ratio. The payables turnover ratio measures the number of times your business recycles, or "turns over" its payables in a year. A higher ratio suggests you pay your accounts payable sooner. Too high of a ratio may suggest you pay "too soon." To calculate payables turnover, divide purchases by average accounts payable.
If vendors did not offer discounts or penalize you in any way, you would naturally stretch out payments, which lowers your payables turnover ratio. For business-relationship reasons (as well as the possibility of late fees), however, it's important to evaluate the trade-off in paying late with the risk of alienating your vendors.
- Average number of days of payables outstanding. Average number of days of payables outstanding (days payable) measures the number of days it takes, on average, to pay the balance of your accounts payable. This ratio is simply the inverse of the payables turnover ratio.
To calculate days payable, divide the number of days in a year (365) by the payables turnover ratio. For example, if your inventory turnover ratio is 8, days payable is equal to 45.6 days (365/8). Ideally, days payable should be no longer than the payment terms offered you in trade credit.
Trade vendors are likely to offer a discount for early payment. For example, "2/10 net 30" offers you a 2% discount of the invoiced amount for paying within 10 days.
Paying early is often mutually beneficial to you and the vendor. You save on the amount paid and the vendor collects sooner. In this case, he gets paid 20 days sooner. Since you don't owe payment in full for 30 days, paying a vendor early is similar to loaning him the money for 20 days.
A rule of thumb is to take the discount and pay early if the interest rate you can earn on this "loan" is greater than your cost to borrow. The following formula is used to calculate the annual interest rate:
- Annual interest rate = (% discount) / (100 - % discount) *
(360 / number of early-days paid)
If we enter our numbers, we get 36.73%:
- (.02 / .98) * (360 / 20) = 36.73%
The formula can be modified to reflect your trade vendor's effective interest rate:
- Effective interest rate = ((1 + (% discount) /
(100 - % discount))^(360 / number of early-days paid) - 1
If we enter our numbers, we get 43.86%:
- (1 + (.02 / .98))^(360 / 20) - 1 =
(1.0204^18) - 1 = 43.86%
Since the annual interest rate is compounded, the effective interest rate is an even higher interest rate. Both of these interest rates are likely to be much higher than your cost of funding. As a result, you can safely conclude that taking the discount is a good financial choice.
This educator has aimed to point out some of the ways you can improve the cash flow of your small business. You may wish to consult your accountant for advice on using any of these techniques
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