Whether you’re purchasing parts for inventory, purchasing accessories or purchasing supplies of any kind, you are no doubt dealing with one or more vendors. Depending on the vendor you are dealing with, they may offer a discount for early payment, customarily known as a trade credit. The best return on your investment for whatever you happen to be purchasing is, most likely, this discount or trade credit.
The trade credit is offered by vendors when they can’t afford to carry accounts for long periods and prompt payment is critical to their cash flow, or when they simply want to induce the customer to pay within 30 days. Owners of small parts stores who are making relatively minuscule purchases from vendors offering trade credits may not deem it worthwhile to pursue the credits. Don’t, however, rule out examining the return potential before making any decision. Those owners or managers of large distributors that make consistent and significant purchases certainly would benefit from such credits if they aren’t already taking advantage of them. In any case, all owners and managers should examine such purchases and discuss the issue with their accounting office.
Calculating the Costs
There are two ways of looking at the costs associated with not taking advantage of trade credits. These costs are easily calculated. The following example illustrates calculating trade credit return and costs.
Let’s say the vendor invoice amount for your purchases totals $6,000. The standard terms for payment are net 30 days. A 2 percent discount ($120) is offered by the vendor if the invoice is paid within 10 days.
Calculating the resulting interest rate on the trade credit is as follows:
$120 ÷ $6,000 = .02
.02 x 100 = 2%
Because the vendor is offering a discount (trade credit) at 10 days and is asking for net invoice amount at 30 days, the vendor seems to be giving you a loan for 20 days (30 days minus 10 days). When assessing the discount potential over a period of a year, the credit becomes quite a substantial return on your investment. There are 18.25 20-day periods (365 days ÷ 20 days) in a year. Accordingly, .02 x 18.25 = 0.365
0.365 x 100 = 36.5%
From this calculation and example, you can see that by not taking advantage of the discount, you would be forfeiting a 36.5 percent return on your investment. In general, the yield on terms of “2/10, net 30” (the same as saying 2 percent discount if paid within 10 days, or net invoice if paid in 30 days) would be 36.5 percent annually.
With trade credits, the longer the lending period, the shorter the yield; the shorter the lending period, the higher the yield. Obviously, if a discount is missed, payment should not be made until the latest payment date allowed by the vendor.
In an extreme example, given the previous terms discussed, if payment was made on the eleventh day, the approximate annual cost of missed discounts is a whopping 730 percent (2 percent x 365 days).
Two conditions should be met before deciding on making early payment to take advantage of a trade credit. First, the cost of money to the business is less than what the terms of the trade credit will produce. In the example shown here, a 36.5 percent return certainly would be worth it. The second consideration is the availability of money. If the business has poor cash flow and difficulty obtaining credit, then it might be impossible to take advantage of the discounts, no matter how attractive they might seem.
Depending on the amount and type of such purchases made by a parts operation, trade credits can offer an added way to maximize the return of an acquisition investment.
The success and future growth of a parts distributor depends largely on purchasing habits, such as the careful examination of trade credits. Carefully planned and studied purchasing reduces acquisition and holding costs, thereby reducing true parts costs, resulting in higher profits. These benefits are obtainable through a policy that emphasizes:
Centralized purchasing through informed management;
Parts stocked according to value qualifiers;
Vendor performance evaluations on a regular basis;
The use of purchase orders as a means of purchase control;
An accurate special order system that is convenient to customers and responsive to their needs, and
Systemized record keeping and document control.