Credit terms and the cost of credit
/What are Credit Terms?
Credit terms are the payment requirements stated on an invoice. It is fairly common for sellers to offer early payment terms to their customers in order to accelerate the flow of inbound cash. This is especially common for cash-strapped businesses, or those that have no backup line of credit to absorb any short-term cash shortfalls. The credit terms offered to customers for early payment need to be sufficiently lucrative for them to want to pay early, but not so lucrative that the seller is effectively paying an inordinately high interest rate for the use of the money that it is receiving early.
Types of Credit Terms
The term structure used for credit terms is to first state the number of days you are giving customers from the invoice date in which to take advantage of the early payment credit terms. For example, if a customer is supposed to pay within 10 days without any discount, the terms are "net 10 days," whereas if the customer must pay within 10 days to qualify for a 2% discount, the terms are "2/10". To expand upon the last example, if the customer must pay within 10 days to obtain a 2% discount, or can make a normal payment in 30 days, then the terms are stated as "2/10 net 30".
The concept of credit terms can be broadened to include the entire arrangement under which payments are made, rather than just the terms associated with early payments. If so, the following topics are included within the credit terms:
The amount of credit extended to the customer
The time period within which payments must be made by the customer
Early payment discount terms
The penalty to be charged if payments are late
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What is the Cost of Credit?
The cost of credit is the effective rate of return that a business offers its customers when it provides early payment terms to them. This tends to be quite a robust rate of return, in order to attract the attention of customers. Given its high cost, a business should only offer early payment terms if it has an extreme need for cash.
How to Calculate the Cost of Credit
You should be aware of the formula for determining the effective interest rate that you are offering customers through the use of early payment discount terms. The formula steps are:
Calculate the difference between the payment date for those taking the early payment discount, and the date when payment is normally due, and divide it into 360 days. For example, under 2/10 net 30 terms, you would divide 20 days into 360, to arrive at 18. You use this number to annualize the interest rate calculated in the next step.
Subtract the discount percentage from 100% and divide the result into the discount percentage. For example, under 2/10 net 30 terms, you would divide 2% by 98% to arrive at 0.0204. This is the interest rate being offered through the credit terms.
Multiply the result of both calculations together to obtain the annualized interest rate. To conclude the example, you would multiply 18 by 0.0204 to arrive at an effective annualized interest rate of 36.72%.
Thus, the full calculation for the cost of credit is:
Discount %/(1-Discount %) x (360/(Full allowed payment days - Discount days))
Accounting for Credit Terms
When a customer takes an early payment discount to pay for an invoice, the accounting for the transaction is:
Debit cash for the amount of cash received
Debit sales discounts for the amount of the early payment discount
Credit accounts receivable for the full amount of the invoice
This entry effectively clears the invoice from the aged accounts receivable report, since it has now been paid in full.
Credit Terms Table
The following table contains a number of standard payment terms, what they mean, and the effective annual interest rate being offered under these credit terms (if any).
