Question

Explain what credit terms are, such as 1/10 net 60 days. What does it mean, provide calculation with explanations? How does interest relate to credit terms?

Answer 1

A credit term in the form 1/10 net 60 days implies that the company is offering 1% discount for payment within 10 days ( ...... i.e 1/10) otherwise, customer can choose to to pay at any time before expiry of 60 days.

Thus in the expression, 60 days is the actual credit period without any discount offer. However to encourage the habit of early payments customer is offered 1% discount for payment within 10 days.

Suppose a transacton worth $ 100,000 was done by customer on account on 1/1/2018. If he choose to pay $ 60000 on 10/1/2018.

He will pay 60000 - 1% = 59400

For balance if paid on 28/2/2018 ( before expiry of 28 days) ........ He had to pay without any Interest. That is 100,000 - 60000 = 40000 balance is fully payable.

How does interest relate to credit terms

Here a careful observation of discount rate looks like an interest rate if one uses the concept of oppurtunity cost. 1% possible income is forgone if we opted to pay on 60th day instead of 10th day. Which means 1% is like an interest for 50 days ( 60 - 10)

Thus in annual terms ........ 1% * 365/50 = 7.3% Interest equivalent can be identified in this expression.

If a customer of this business finds his personal finance costs more than 7.3%, he can actually avail 60 days credit period. Otherwise where had alternative oppurtunity that cost much lower than 7.3% then he can use the discount offer and pay within 10 days. Thus choosing from the option depends on individual customers credit ratings and interest burdens.

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