Trade Discount

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Trade Discount Option



Considering a trade discount option for the refurbishment undertaken by a Charity Organization

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1. INTRODUCTION -------------------------------------------------------------------------------------------2. LOAN FACILITY OR TRADE DISCOUNT OFFER -----------------------------------------------------3. TRADE DISCOUNT TERMS ------------------------------------------------------------------------------4. THEORY IMPLICATIONS ---------------------------------------------------------------------------------5. CONCLUSION ----------------------------------------------------------------------------------------------REFERENCES ---------------------------------------------------------------------------------------------------

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1- INTRODUCTION It is always a challenge for the small and charitable organizations to arrange financial resources for their continued existence and growth (Harrison et al., 2004). In order to support such organizations in terms of financing for their projects, many suppliers offer trade credit facility that allows buyers to pay early or delay the payment on the basis of agreement (Petersen and Rajan, 1997). „Trade discount‟ is the distinctive form of trade credit that allows the organizations to pay sooner to their suppliers (Bosse and Arnold, 2010). For instance, a firm can get trade discount of 3% if the payment will be made within 10 days, otherwise the full payment will be due at the end of the month. Today, the use of trade discount is so common in small product and service oriented organizations (Ebben and Johnson, 2006). In this report, the author is reporting to the managing director of a charity organization that is currently undertaking a major refurbishment of its premises in order to improve them to allow the charity to earn additional income as a conference centre. The total amount of £30,000 is required for the refurbishment of licensed bar. The potential supplier has offered two options: either to provide a five year loan or to offer trade discount for a period so that charity can pay the amount on the basis of terms and conditions mentioned in the agreement. In this report, a comprehensive discussion will be made on how the second option should be accounted for. Trade discount which is also called functional discount is described by Clayman et al. (2008) as “the importance of credit to the company and its ability to evaluate trade credit opportunities, such as trade discount, encourage standardized payables procedures and enhanced information management throughout the company”. Bosse and Arnold (2010) argued that trade discount option is meaningful and a real option for small organizations because it gives the opportunity of taking advantage from early payment. Moreover, the provision of trade discount creates a real option for the firm that affects its cost of capital. The trade discount may have dramatic impact on the cost of the capital of the firm. Suppose, the discount rate offered by the supplier to charity organization is 1% and the organization delays the payment beyond the discount period (i.e. 10 days); it means that the organization missed discount opportunity and annual cost of capital will be increased. In showing the importance of trade discount Bosse and Arnold (2010) state that trade

discount is the useful way to reduce the working capital amount but many firms including charity organizations usually ignore the offers of trade discount by suppliers (Elliehausen and Wolken, 1993). 2- LOAN FACILITY OR TRADE DISCOUNT OFFER Petersen and Rajan (1994) state that the organizations are likely to explore other sources of credit including trade credit if they are unable to obtain bank loans. Danielson and Scott (2004, p. 581) clearly mentioned that “if a firm makes timely payments, trade credit can be a complement to bank loans in its capital structure. However, when a firm cannot make timely payments, perhaps because it faces cash flow constraints and additional bank loans are not available, trade credit can be an expensive source of funds and can be a substitute for bank loan” In comparing bank loan with trade discount offer, Ferris (1981) specify that trade credit option is beneficial for the firms in terms of quality control because using this facility the organizations may effectively match cash outlays timing for cost of goods sold with sales cash receipts. Similarly, some other experts also opine the importance of trade credit discount by explaining its benefits. According to Copeland (1980), the major advantage of trade discount is that it shortens the average collection/payment period. Usually, the income streams of charity organizations are stable in the beginning of the month. Therefore, the best option for the organization is to accept the option of trade discount so that they can pay to supplier sooner. Banerjee (2010) pointed out that the rate of trade discount is fixed but different prices are charged for different types of organizations so that it increases the purchasing power of firms. For the charity organization, earning addition income as a conference centre may need to spend money on other resources. The organization may save money through supplier‟s trade discount offer and can use saved capital for acquiring other resources. There is not extensive literature available in explaining how and when firms can use trade discounts offered to them. Petersen and Rajan (1997) specified that small organizations utilize the facility of trade discount credit because these facilities offered by other financial institutions (e.g. banks) tend to be more expensive. They further mentioned that


small firms rely on trade discount credits because normally they do not fulfil the high credit and loan requirements of financial institutions especially, in case of charitable organizations where funds are not consistent. In reality, the trade discount facility is similar to American call option where the option can be exercised before its expiration date (Apostolou and Apostolou, 2005). In this case, the market value of underlying security is greater than the strike price (or exercised price). The underlying security is the specific stock on which the option is based (Essvale Corporate, 2010). It is basically, the ability of the firm to produce cash flows either by carrying out its operations or by considering other options such as bank credits. In addition, the significance of underlying security will also have an effect on charity‟s short term cash outflows. If the charity firm has the option to pay £30,000 later (after specified period) according to the terms of trade discount agreement and the will not utilize the benefits of trade discount with the thinking that it may create problems in future payment obligations then there is a possibility of increase in cost of capital. According to Brigham and Besley (2000), paying on full invoice amount without utilizing the trade credit discounts could be more expensive for the firms as compare to other forms of credits. 3- TRADE DISCOUNT TERMS Roncagli and Bathala (2007) state two types of trade terms. In the first type no trade discount is offered by the supplier and agreement consists of expiry date by which the full payment is due with little interest. On the other hand, the second term is used when supplier offer trade discount. This term is based on three things: discount amount (or discount rate), time period during the discount can be taken, and final date until then full payment can be made. For example, “2/10 net 30” means 2% discount rate if the buyer will pay within 10 days, otherwise the full payment can be made within 30 days (Clayman et al., 2008). In normal practice, the firms accept the offers of trade discount when greater cash flows are generated in exercising the option. In the given scenario, there is no particular discount rate is mentioned. So, in this section, the attempt will be made to evaluate two


possible options that supplier may offer to charity firm based on either higher percentage or longer time period. According to Bosse and Arnold (2010) if the organizations are offered larger trade discounts by suppliers for sooner payment (i.e. 2/10 net 30), the managers of the organizations will be motivated to take higher percentages of the trade discount offered. Suppose the charity organization needs to pay £30,000 in 5 years after accepting the offer of trade discount with the assumption that supplier does not charge additional interest if the payment is made within the discounted period.
Annual payment: £30,000/5 = £6000 Case1: 1/10 net 30 (Lower percentage) (1% discount if paid within 10 days, full payment is due in 30 days) Annual report entry If paid within discount period £6,000 * 0.01 = £60 discount received Case2: Term: 2/10 net 30 (Higher percentage) (2% discount if paid within 10 days, full payment is due in 30 days) Annual report entry If paid within discount period £6000 * 0.02 = £120 discount received

£6,000 - £60 = £5,940 will show in annual report £6000 - £120 = £5,880 will show in annual because trade discounts are not shown in books report because trade discounts are not shown in of accounts (Pratt, 2010) books of accounts (Pratt, 2010) If not paid within discount period (1/99)x(360/10) = 36.36% additional cost £6,000 * 0.3636% = £2181.6 additional payment If not paid within discount period (2/98)x(360/10) = 73.47% additional cost £6,000 * 0.7347% = £4,408.2 additional payment

£6,000 + £2181.6 = £8181.6 will show in annual £6,000 + £4,408.2 = £10,408.2 will show in report because trade discounts facility was not annual report because trade discounts facility was availed not availed

It can be seen from above example that if the charity organization will go for higher percentage (i.e. 2%), it can save double amount but on the other hand, if the payment is not made within the discount period the organization will liable to pay £10,408.2 within 30 days. Alternatively, if the supplier has offered longer period of time with lower percentage the scenario will be different (Bosse and Arnold, 2010).

Annual payment: £30,000/5 = £6000 Case: 1/20 net 30 (1% discount if paid within 20 days, full payment is due in 30 days) Annual report entry If paid within discount period £6,000 * 0.01 = £60 discount received Annual report entry If not paid within discount period (1/99)x(360/20) = 18.18% additional cost

£6,000 - £60 = £5,940 will show in annual report £6,000 * 0.1818% = £1090.8 additional payment because trade discounts are not shown in books £6,000 + £1090.8 = £7090.8 will show in annual of accounts (Pratt, 2010) report because trade discounts facility was not availed

The above illustration shows that it could be beneficial for the charity organization to accept the longer period offer with lower percentage because in this case if the payment is not made within discount period, the organization will be liable to pay £7090.8 instead of £8181.6 within 30 days. Basically, it depends on the growth of charity organization, if the organization is successful in obtaining healthy funds, it can accept the higher percentage offer with shorter time period and if the funding stream is not stable and the organization is struggling then option 2 is beneficial. So, it can be said that there is a positive relationship between growth rate of the firm and percentage of trade discount (Bosse and Arnold, 2010). These options are graphically displayed in figure 1.
Figure1: Trade discount decision tree

Source: Bosse and Arnold (2010)

4- THEORY IMPLICATIONS Petersen and Rajan (1997) and Danielson and Scott (2004) applied Pecking Order theory to trade credit discounts (Roncagli and Bathala, 2007). Eckbo (2008, p.150) reported that according to Myers (1984), “a firm is said to follow pecking order if it prefers internal to external financing and debt to equity if external financing is used”. Trade credit is a form of debt, and it is shown in the previous sections that if the payments are made within discount period then trade discount is beneficial for any organization as compared to other sources of finance such as bank loan. According to the Pecking Order theory, the charity organization should accept trade credit discount if internally produced funds are available to it. 5- CONCLUSION From the above discussion, it is clear that the trade discount offer could be beneficial for the charity organization if the payments are made within the discount period, otherwise the firm will face more penalties and obligations based on agreement terms. It is better for the charity organization, to accept the longer period offer with lower percentage because in this case if the organization will not able to made payment within the discount period, the full payment will cost lower than the higher percentage offer. However, it depends on the growth of charity organization, if the organization is successful in obtaining healthy funds, it can accept the higher percentage offer with shorter time period and if the funding stream is not stable and the organization is struggling then option of lower percentage with longer discount period is beneficial.



Apostolou, N. and Apostolou, B., (2005). Keys to investing in options and futures. 4th edition, Barron‟s educational series Banerjee, B. K., (2010). Accountancy for class XI, PHI learning Bosse, D. A. and Arnold, T., (2010). Trade credit: a real option for bootstrapping small firms, Venture Capital Taylor and Francis, 21(1), pp. 49 – 63 Brigham, E. F. and Besley, S., (2000). Essentials of managerial finance, 12th edition, The Dryden press Clayman, M. R., Fridson, M. S. and Troughton, G. H., (2008). Corporate finance: a practical approach. John Wiley and Sons Copeland, R. M., Dascher, P. E. and Davison, D. L., (1980). Financial accounting, Wiley Danielson, M. G. and Scott, J. A., (2004). Bank loan availability and trade credit demand, The financial review, 39, pp. 579 – 600 Dixit, A., (1992). Investment and hysteresis, Journal of Economic Perspectives, 6, pp. 107– 132 Ebben, J. and Johnson, A. (2006). Bootstrapping in small firms: An empirical analysis of change over time, Journal of Business Venturing, 21, pp.851–865 Eckbo, B. E., (2008). Handbook of corporate finance: empirical corporate finance, Elsevier Elliehausen, G.E. and J.D. Wolken, J. D., (1993). The demand for trade credit: An investigation of motives for trade credit use by small businesses. Washington, DC: Board of Governors of the Federal Reserve System Essvale Corporation, (2010). Investment banking applications, Essvale corporation publications Ferris, S., (1981). A transactions theory of trade credit use, Quarterly Journal of Economics, 96, pp. 243–270


Harrison, R.T., Mason, C.M. and Girling, P., (2004). Financial bootstrapping and venture development in the software industry. Entrepreneurship and Regional Development, 16, pp. 307–333 Long, M., Malitz, I. and Ravid, S., (1993). Trade credit, quality guarantees, and product marketability, Financial Management, 22, pp. 117–127 Petersen, M. and Rajan, R., (1994). The benefits of firm-creditor relationships: Evidence from small business data, Journal of Finance, 49, pp. 3–37 Petersen, M.A. and Rajan, R.G., (1997). Trade credit: Theories and evidence. Review of Financial Studies, 10(3), pp. 661–691 Pratt, J., (2010). Financial accounting in an economic context, 8th edition, John Wiley and Sons Roncagli, B. and Bathala, C., (2007). Determinants of the use of trade credit discounts by small firms, FMA Meetings, pp. 1 – 34 Smith, J., (1987). Trade credit and information asymmetry, Journal of Finance, 42, pp. 863– 869


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