Finance

When to use an early payment discount?

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.