Small Business Taxes & ManagementTM--Copyright 2011, A/N Group, Inc.
It's not unusual for vendors to offer a discount for early payment of an invoice. For example, a typical offer is 2/10 net 30. That means you'll get a 2-percent discount if you pay the invoice within 10 days; if you don't take the offer the full amount is due in 30 days. As the customer, the question is, should you take the discount? As a vendor, the question is, should you offer a discount?
The first step is, unfortunately, a review of the math. The good news is that it's not complicated. The formula is:
Example: Madison Inc. is going to pay an invoice with terms of 2/10, net 30. Plugging into the formula:Effective interest rate = discount %/(100-discount %) X 360/(FT - DP) Where: FT = the full term allowed for payment in days DP = the discount period allowed for payment in days
Thus, taking the discount is equivalent to earning almost 37% a year on your money. That sounds high, but it makes sense when you look at the details. You're getting a 2-percent discount, but that saving is spread over just 20 days, the difference between the regular due date and the discount period. Had the terms been 2/10, net 60, that same 2-percent discount would have been spread over 50 days (60 less 10) and the effective interest rate on an annual basis would be about 15%.Effective interest rate = 2/(100-2) X 360/(30-10) = 2/98 X 360/20 = 36.7
One of the biggest assumptions in the formula is that you take the discount at the last possible day and you normally would pay on the last day of the nondiscount period. To give you an idea of how the numbers work for various combinations, here's a table of some common combinations:
Remember, the number of days in the second column is the number of days between the last day of the discount and the final date of the invoice. You can see that when the time between the discount date and the final date is short, 15 or 20 days, the savings are significant. That saving is even greater if the discount is 2% instead of 1%. And terms of 1/10 net 40 produce the same effective interest rate as 1/20 net 50 since the difference between the full term and the discount period is the same, 30 days.Percent Full Term less Effective Discount Discount Period Interest Rate 1% 15 24.2% 1 20 18.2 1 25 14.5 1 30 12.1 1 50 7.3 2 15 49.0 2 20 36.7 2 25 29.4 2 30 24.5 2 50 14.7 1/2 20 9.0
Before going further, note that we used 360 as the number of days in the year. It would be more accurate to use 365, but the difference is small. On the typical 2/10 net 30, using 365 results in an effective rate of 37.2% instead of 36.7%. Generally other factors would outweigh the interest rate difference.
You can't just look at the numbers from the formula. There are times to take the discount and times to offer one and times to say no on both sides.
Cost of capital. First, you've got to compare taking or giving the discount to your cost of capital. That can vary widely, particularly for a small business. The cost of capital is a mix of what debt capital would cost (e.g., a bank loan) and the cost of equity capital (selling stock). For many small businesses the cost of capital ranges between 15 and 20 percent. It could be less for an established, well-capitalized business in a stable or growing market, or much higher for a risky one, a startup, etc. If your cost of capital is less than the discount, you should take the discount. On the other hand, offering a discount generally makes sense only if your cost of capital exceeds the discount. But see below for points that modify this logic.
Use for money. No matter what your cost of capital, taking the discount makes sense if you've got no use for the money. For example, you've got considerable cash on your balance sheet which you're saving to put down on a new building and you've got little or no debt (except for payables). Or you and your brother are the sole owners of the enterprise and don't need the funds personally. If that's the case, you should take the discount even if the effective interest rate is relatively low. On the flip side, offering a discount doesn't make sense if you don't have to improve your cash flow.
Margins. Business margins vary. We know one small business that does several million a year in sales, but the margins are often 8% or less. Offering even a 1% discount would severely impact his bottom line. The higher your margins, the easier it is to afford to offer a discount.
Short-term needs. Offering or taking the discount may be dictated by your short-term capital needs. For example, Madison has a number of large orders in the pipeline and three months from now it'll have plenty of cash. But between now and then, it's having trouble making payroll. Offering a discount to customers who might otherwise stall may speed up payments enough to get over a rough patch. But it's generally not cheap capital. Which means it's not a viable long-term solution to your financing problems. In fact, it's a sign you probably need additional capital.
Cheaters. Almost every business that provides a discount for early payment finds at least one customer cheating--that is, taking the discount and paying beyond the discount period. That's something you've got to deal with, in some cases on a customer by customer basis.
Talk to your accountant or financial adviser. He or she should be able to provide additional help.
Copyright 2011 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 07/29/11