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Entries Tagged as 'early payment discount'

When to use an early payment discount?

December 15th, 2009 · No Comments · Finance

In this article I will explain the standard terminology used to describe early payment discounts. I will then present a simple approach towards deciding whether to use early payment discounts.

What does “2/10 net 30″ mean?

Early payment discounts are often described using a phrase like “2/10 net 30″. What does it mean? “2/10 net 30” means that the payment is due in 30 days, but the payment is made within 10 days then the payee will get a 2% discount.

Let us break this down in terms of measures we all can easily understand. Let us say a vendor offers you “2/10 net 30″ payment terms. Let us say that there is an outstanding invoice from that vendor for $10,000. In other words, you owe the vendor $10,000 to be paid within 30 days. But if you pay the vendor within 10 days, he is going to give you 2% discount on that $10,000 (equal to $200 in discount)

Early payment discount can be described as an annual interest rate

If you look at the same information from a different angle, the vendor is giving you $200 for getting your money 20 days in advance. Now look at another scenario. What if your bank tells you that, they will give you $200 on your $10,000 if you let them have the money for 20 days. Is this bank offer the same as the vendor offer in financial terms? Turns out that these two offers are one and the same. If such a bank existed, then you might as well deposit your $10,000 for 20 days, earn that $200, and then pay the vendor on the 30th day with $10,000, and pocket the $200. This is the same as paying the vendor $9800 on the 10th day.

Once you agree with that, what is the annual effective interest rate for such a bank account. Let us see. For 20 days, you got 2%. Therefore, for 360 days, you will get 2%*(360/20) = 36% interest. In other words, a vendor that gives you a “2/10 net 30” term is giving you an opportunity to earn 36% annual interest on your cash. That sounds like a great deal, but is it really?

Should I accept an early payment discount?

Here is where the cost of money argument comes to play. As I explained in an earlier article, cost of money of your business is the average interest rate on the money supply into your business. Let us say [based on the calculations explained in the previous article]  your cost of money is 8.67%. In effect, you are borrowing money at 8.67% from your creditors, and then depositing that money at the vendor, and earning an interest rate of 36%. Does that sound like a steal to you? That is because in this case it actually is.

Should I offer an early payment discount?

Now let us reverse the roles and see. What if you are the vendor who is offering “2/10 net 30” terms to your customer? In effect, you are providing the customer with a bank account that provides 36% interest rate. Your business is already borrowing money at 8.67% from your creditors. And now you are offering to borrow money from the customers at 36%? Is that a good deal to you? If you can keep borrowing money from your creditors at 8.67%, this clearly is not a good deal for you.

But if you are running out of cash, and are unable to borrow any more money at 8.67%, then try if you can find another source to borrow money at a rate less than 36%. Offering early payment discounts should be your last resort, if you can no longer borrow money for anything less than 36%.

As explained above, before you take up an early payment discount from your vendor, or before you offer an early payment discount to your customer, think about what the cost of money for your business is.

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4 simple steps to calculate the Cost of Money for your small business

December 15th, 2009 · 1 Comment · Finance

Cost of money refers to the average interest rate at which you are able to borrow money. Think of the cost of money as the rent you have to pay for using someone else’s money.

Yes, there is a cost of money even if you are using all of your own money. How? Since you are using your own money instead of putting it into a savings account, you are foregoing the 1.5% interest you could make on it. Thus, the cost of money in this case is 1.5%.

As a small business owner, you probably borrow money from several sources, e.g., bank, credit cards, friends. You probably also keep money in various places, e.g., checking account, savings account. Each of these sources has its own cost of money: A bank loan could cost you 10%, a credit card could cost you as much as 30%, and so on and so forth. So how do you come up with the combined cost of money that tells you how much interest you are paying for all of this borrowed money?

The short answer is that your cost of money is the weighted average of your borrowing and deposit interest rates. Too much jargon? Don’t worry. In the next section I will explain how to calculate your cost of money in 4 simple steps.

4 Simple Steps to Calculate the Cost of Money for Your Small Business

Let us create a spreadsheet with 4 columns.

Step 1 (Column A) - Identify all of the sources of money for your business and list them in order. These sources are often:

  • Small business loans from a bank or SBA.
  • Credit cards. If you use multiple credit cards, then list the amounts your have charged on each one of them separately. (Note: Do not list your credit limit, but rather your outstanding balance. If your outstanding balance changes every month, your cost of money will also change every month.)
  • Friends or family who have lent you money to run your business. (Write down the amount even if they are not charging you any “interest” on the loan.)
  • If your business has cash lying in a checking or saving account, list that too.

Step 2 (Column B) - Next to each source, write down the interest rate you are paying. For SBA, this rate can be easily found in your documents. If you use multiple credit cards, write down the APR of each card separately. You can find out the APR from your credit card statements, or you can call the credit card companies.

Step 3 (Column C) – Apply a + or – sign to each source.

  • If your business has “borrowed” money from that source, then use a + sign. Bank loans, SBA loans, Credit cards, Friends/Family will get a + sign.
  • If you business has “deposited” money into that source, then use a – sign. Your business checking account balance and your savings account balance will all have – signs.

Step 4 (Column D) – Time to find your weighted average. You can do this by simply multiplying column A with Column B, and applying the sign in Column C to get Column D. (See table below.)

Once you finish Step 4, now, add all of the rows in Column A and all of the rows in Column D. After you do that, divide the Column A total by the column D total. This amount is the cost of money for your business. Simple, huh?

Calculate cost of money in 4 steps

Calculate cost of money in 4 steps

Based on the table above -

Cost of Money = $21,406.89 / $238,665.54 = 0.0897 = 8.97%

As you can see, the cost of money is the weighted average interest rate for the money supply into your business.

Applying cost of money as a metric

Cost of money is a very useful metric in making business decisions. For example, cost of money can be used to decide whether to offer / accept early payment discounts.

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