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 a discount is not utilized, you can use the Formula Method. The formula is as follows:
Effective Interest Rate = (Discount % / (1 - Discount %)) x (365 / (Full Credit Period - Discount Period))
Now, let's break down the formula and understand each component:
1. Discount %: This refers to the discount percentage offered by the vendor for early payment. For example, if the vendor offers a 2% discount for early payment, the discount % would be 0.02.
2. Full Credit Period: It is the maximum period within which payment can be made to the vendor without incurring any penalties or interest charges. For instance, if the vendor allows payment within 30 days, the full credit period would be 30.
3. Discount Period: This represents the number of days within which the discounted payment must be made to avail the discount. If the vendor specifies that the discount is applicable within 10 days, the discount period would be 10.
4. 365: This value represents the number of days in a year and is used to convert the effective interest rate into an annual percentage.
By plugging in the values for the discount %, full credit period, and discount period into the formula, you can calculate the effective interest rate.