ACCA FM Syllabus C. Working Capital Management - Early Settlement Discounts (Creditors) - Notes ^{1 / 1}

Clearly it is best to take as much advantage of trade credit as possible. Paying later is almost always beneficial.

However, a company needs to ensure it does not annoy its vital suppliers by missing deadlines and also the company may seek to take advantage of early settlement discounts.

Early settlement discounts

Trade credit is a simple and often free source of finance. (It is not free, however, if an early payment discount is foregone)

• Method

  Simply compare:

  1. Current Savings (the more payables the better)

  2. New policy Savings (Less payables but receive an early settlement discount)

Illustration

Discount of 1% for an early settlement on goods worth 1,000,000pa if paid in 10 days (normal terms 30 days)

Overdraft interest rate is 10%

• Current Savings
   
  Payable saving:
  30/365 x 1,000,000 x 10% = $8,219

• New policy Savings

  New Payables saving: 10/365 x 1,000,000 x 10% = $2,740
  Discount saving: 1% x 1,000,000 = $10,000
  TOTAL = $12,740

• Company should take the discount as the savings are higher

How to quickly calculate an annual interest rate

• Take 100 and divide it by 100-discount % offered

• Multiply this by the power of 365/reduction in days

• Take the 1 off and voila!

Illustration 1

• 5% early settlement discount if customers pay within 10 instead of 60 days.

• As a percentage cost this is:
  ((100/95) power of 365/50) - 1 = 45.42%

Illustration 2

Cow Co is considering accepting a discount of 2% from his supplier if he pays within 20 days rather than the current 35 days. 

There are 365 days in the year.

Required:
What is the annual interest rate?

• Annual interest rate = ((100/(100 – 2)) power of (365/15)) – 1 = 63·5%