## Management of Payables (Creditors)

> Old business saying: "If you can buy well, then you can sell well."

Managing creditors/suppliers is as important as managing debtors:

Trade credit is a spontaneous, short-term source of finance — it arises automatically from ordinary business transactions.
Slow payment may create ill-feeling, disrupt supplies, and damage the company's image.
Creditors are a vital part of effective cash management and must be managed to enhance the cash position.

## Computation of Cost of Payables

Using trade credit judiciously reduces the burden of investment in working capital. The key question is: what is the cost of NOT taking the discount offered for early payment?

### Nominal (annual) cost — ignores compounding

```

Nominal cost = [ d / (100 - d) ] x [ 365 / t ]

```

### Effective cost — accounts for compounding

```

Effective cost = [ (100 / (100 - d)) ^ (365 / t) ] - 1

```

Where:

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

The effective formula gives a higher cost than the nominal formula because it captures the compounding effect.

### Interpretation

If the cost of forgoing the discount is higher than the firm's cost of short-term funds, it is worth borrowing to pay early and take the discount.

Worked example

### Example 1

Cost of forgoing a 2/10, net 45 discount

Terms '2/10, net 45' mean: 2% discount if paid within 10 days, otherwise full amount due in 45 days.

d = 2, t = 45 - 10 = 35 days
Nominal cost = [2 / (100 - 2)] x [365 / 35] = 0.020408 x 10.4286 = 21.28% p.a.
Effective cost = [(100 / 98) ^ (365 / 35)] - 1 = (1.020408 ^ 10.4286) - 1 = 23.45% p.a.

Since this far exceeds typical short-term borrowing rates, the firm should pay within 10 days and take the discount.

⚠️ Common exam mistakes

Computing t as the full credit period instead of (Days Credit Outstanding − Discount Period).
Putting the discount rate d in the numerator AND denominator incorrectly — denominator is (100 − d), representing the amount actually paid.
Using the nominal formula when the question asks for the effective/true cost (which requires the compounding exponent 365/t).
Treating trade credit as a 'free' source — forgoing a cash discount has a real, often very high, implicit cost.

Reference:

Now that you've read this — what's next?

Move from understanding → mastery in 3 clicks. Each option below picks up from this lesson's topic.

🔥 Drill 5 Qs on this → ✍️ Adaptive practice →

Management of Payables and Cost of Trade Credit (Cost of not taking discount)

Worked example

⚠️ Common exam mistakes