An important source of temporary cash is trade credit, which does not actually bring in cash, but instead slows its outflow. Vendors often provide discounts for early payment. What is the formula to determine the effective interest rate if the discount is not utilized?
To determine the effective interest rate when the discount is not utilized, we can use the formula for the cost of trade credit:
Effective Interest Rate = (Discount % / (100 - Discount %)) * (365 / (Payment Days - Discount Days))
Where:
- "Discount %" is the percentage of discount offered by the vendor for early payment.
- "Payment Days" is the number of days you have to make the full payment to the vendor.
- "Discount Days" is the number of days within which you must make the payment to qualify for the discount.
Let's go through an example to better understand how to calculate the effective interest rate:
Suppose a vendor offers a 2% discount if you pay within 10 days, and you have 30 days to make the full payment. Using the formula, we can calculate the effective interest rate:
Effective Interest Rate = (2 / (100 - 2)) * (365 / (30 - 10))
= (2 / 98) * (365 / 20)
= 0.0204 * 18.25
≈ 0.3735 or 37.35%
Therefore, in this example, if you don't utilize the 2% discount and take the full 30 days to make the payment, the effective interest rate would be approximately 37.35%.
Remember, this formula helps you assess the implied cost or effective interest rate of trade credit if you choose not to take advantage of the discounts offered by vendors.