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Chapter 7 • Managing Short-Term Resources and Obligations 257

APPENDIX 7-B

Credit Terms

An important trade credit issue involves whether an organization should take discounts if offered. W hen a credit discount is offered, it usually pays to take the discount. A formula can be used to determine the annual interest rate implicit in trade credit discounts:

Implicit interest rate

Discount Discounted price

X 365 day s

X lO0O/o days sooner

(7.B.1)

For example, suppose that HOS purchased $5,000 of pharmaceuticals with payment terms of 2/10 N/30. A 2 percent discount on a $5,000 purchase would be $100. This means that if the discount is taken, only $4,900 would have to be paid. By taking the discount, the hospital must make payment by the 10th day rather than the 30th day. This means that payment is made 20 days sooner than would otherwise be the case:

Implicit interest rate

$100 365 days x 100% --X---

$4,900 20 days

= 37.2%

Although the stated discount rate of 2 percent seems· to be rather small, gaining a 2 percent dis­ count off the net price, in exchange for paying just 20 days sooner, represents a high annual rate of return. Suppose that the organization bas $4,900 of cash avail­ able to pay the bill on the 10th day. For it to make sense not to pay the bill promptly and take the dis­ count, we would have to invest the money for the next 20 days in an investment that would earn at least $100 over that period. Any investment that could give us that return would be earning profits or interest at a rate of at least 37.2 percent per year.

That is, $4,900 X 37.2 percent per year X (20 days/365 days) = $100. That means if we sta1ted with $4,900 and earned interest at 37.2 percent per year for a period of 20 days, we would earn $100 in interest. Together with the $4,900 we start with we would have $5,000. If we have projects available to invest in for 20 days that would pay at an annual rate that is even more than 37.2 percent, it would make sense to invest in the projects rather than take the discount. We would earn more than $100 interest for the 20 days and have more than $5,000 at the end of 20 days. We could pay $5,000 and still have something left. But if we can only earn at

an annual rate of return less than 37.2 percent for those 20 days, then $4,900 plus interest would be less than the $5,000 needed to pay the full amount due. So we would be better off just taking the discount and paying the $4,900. Since most organizations do not have avail­ able investments that are assured of earning such a high rate, it pays to take the discount and pay promptly.

Suppose that we do not have the $4,900 in cash to make the payment on the 10th day. However, a bank is willing to lend us $4,900 at an annual inter­ est rate of 10 percent. Ten percent of $4,900 is $490 per year. Dividing this by 365 days in a year comes to $1.34 per day. We only need to borrow the money for 20 days. Twenty times $1.34 is $26.84. That is the amount of interest we would have to pay the bank for the 20-day loan of $4,900. To save $100, we would have to pay the bank about $27. This is clearly a good deal. So even if you have to borrow money to take the discount, you should, as long as you can borrow at an interest rate of less than 37.2 percent per year.

This assumes, of course, that the invoice will be paid on time if the discount is not taken. Suppose, however, that Meals for the Homeless often pays its bills late. Sometimes it pays after two months, or even three months. Would it make sense to take the dis­ count and pay in 10 days or to wait and pay the bill after 90 days? Paying after 10 days is 80 days earlier than the normal 90 days before making our payment:

Implicit interest rate

Implicit interest rate

Discount Discounted price

x 365 days x lO0O/o

days sooner

(7.B.1)

$100 365 days x 100% -- x---

$4,900 80 days

= 9.3%

If Meals can earn more than 9.3 percent on its investments, it should wait to pay the bill. If Meals does not have enough money to pay the bill and a bank would charge more than 9.3 percent, then it is better off waiting, assuming its suppliers are willing to wait to receive payment and do not charge interest for late payments. Otbe1wise, Meals should pay promptly and take the discount.