Effects of Late or Non-payments/Interest
Interest
Assume for a moment that you are a seller and can earn 12% on your money if it were in the bank. This is money that you earned from sales (Sales-Cost=Profit). Assume now that you have agreed to wait for your payment (that is, you have extended credit). Had you not extended credit, hypothetically you would have money from the sale, which would be in the bank earning interest. Extending credit means you are losing the opportunity to earn interest and, therefore, this is a cost.
Another way to consider interest as a cost is to assume you have a loan from the bank. That loan was used to produce your products. Until that loan is repaid, you are charged interest. If the buyer were to give you cash at purchase, you could apply that money to your loan and thus reduce your interest charges and thus your cost. By extending credit to the buyer, you are agreeing to incur interest costs against the money you borrowed in order to produce the product.
Do some math and see how these scenarios might play out (in simple terms). Assume that for each $100 in sales, $95 is cost and $5 is profit. Assume you extend credit and therefore do not receive your monies until some time in the future. If your interest costs are 12% per year (assuming that this money could generate a return of 12% in interest to the seller), your first month’s cost would be $1.00 (12% x $100 = $12.00 divided by 12 months = $1.00). See the table below for additional clarification.
| Sales | Cost | Net Profit | Month | Amount | Profit After Interest Payment |
|---|---|---|---|---|---|
| $100 | $95 | $5 | First | $1.00 | $4.00 |
| $100 | $95 | $5 | Fourth | $4.00 | $1.00 |
| $100 | $95 | $5 | Sixth | $6.00 | ($1.00) |
| $100 | $95 | $5 | Eighth | $8.00 | ($3.00) |
| $100 | $95 | $5 | Twelfth | $12.00 | ($7.00) |
| 
