## Management of Payables (Creditors)

### Why payables matter

"If you can buy well, then you can sell well." Managing creditors and suppliers is just as important as managing debtors.

Trade credit is a spontaneous / short-term source of finance — it arises automatically from ordinary business transactions.
But creditors must be looked after: slow payment can create ill-feeling, disrupt supplies, and damage the company's image.
Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position.

### Computation of Cost of Payables (Cost of Not Taking the Discount)

When a supplier offers a cash discount for early payment, forgoing that discount has an implicit cost. By using trade credit judiciously, a firm can reduce the burden on working capital — but it must weigh the cost of losing the discount.

Nominal (simple) annual cost of not taking the discount:

$$\text{Cost} = \frac{d}{100 - d} \times \frac{365 \text{ days}}{t}$$

Effective cost (accounting for compounding): the nominal formula ignores compounding, so the true cost is higher:

$$\text{Cost} = \left(\frac{100}{100 - d}\right)^{\frac{365}{t}} - 1$$

Where:

d = size of discount (e.g. for a 6% discount, d = 6)
t = reduction in the payment period in days needed to obtain the early discount = Days Credit Outstanding − Discount Period

### Interpretation

If the cost of forgoing the discount exceeds the firm's cost of borrowing, the firm should borrow and pay early to take the discount. If it is lower, the firm should forgo the discount and use the full credit period.

Worked example

### Example 1

Cost of forgoing a discount on terms "2/10 net 45":

Here d = 2, discount period = 10 days, credit period = 45 days, so t = 45 − 10 = 35 days.

Nominal cost = (2 ÷ (100 − 2)) × (365 ÷ 35) = (2/98) × 10.43 = 0.2040 = 20.40% p.a.

Effective cost (compounded) = (100/98)^(365/35) − 1 = (1.02041)^10.43 − 1 ≈ 0.2345 = 23.45% p.a.

Since this far exceeds a normal borrowing rate, the firm should pay within 10 days to capture the discount.

### Example 2

Identifying t correctly for terms "1/15 net 60":

d = 1, discount period = 15 days, net credit period = 60 days.

t = 60 − 15 = 45 days (the number of extra days of credit gained by forgoing the discount).

⚠️ Common exam mistakes

Taking t as the full credit period instead of (Days Credit Outstanding − Discount Period). t is only the additional days of credit obtained by forgoing the discount.
Putting the discount in the denominator as 'd' instead of '100 − d' — the base is the net amount actually paid, i.e. (100 − d).
Using the nominal formula and forgetting that the effective (compounded) cost is higher — examiners often ask for both.
Forgetting the final decision step: compare the computed cost with the firm's cost of borrowing before recommending whether to take the discount.

Reference:

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Management of Payables — Cost of Not Taking Cash Discount

Worked example

⚠️ Common exam mistakes