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, you can use a formula called the cost of trade credit formula. This formula takes into account the credit terms, the discount percentage, and the payment period to calculate the effective interest rate.
The formula for the effective interest rate when the discount is not utilized is:
Effective Interest Rate = (Discount % / (1 - Discount %)) x (365 / (Payment Period - Discount Period))
Here's a breakdown of the variables used in the formula:
- Discount %: The percentage discount offered by the vendor for early payment.
- Payment Period: The number of days allowed to pay the full amount without taking the discount.
- Discount Period: The number of days during which the discount is available.
To calculate the effective interest rate, divide the discount percentage by (1 - discount percentage), then multiply the result by (365 / (Payment Period - Discount Period)).
For example, let's say a vendor offers a 2% discount for payment within 10 days, with a payment period of 30 days. Using the formula, the calculation would be:
Effective Interest Rate = (0.02 / (1 - 0.02)) x (365 / (30 - 10))
= (0.02 / 0.98) x (365 / 20)
≈ 0.0204 x 18.25
≈ 0.373 or 37.3%
Therefore, the effective interest rate when the discount is not utilized in this scenario would be around 37.3%.