It has always interested me how few businesses actually take prompt payment discounts. I have to assume this is caused by several factors:
- A lack of involvement in the financial aspects of the business by the owner.
- Tight cash flow which seems to push business owners to hoard cash, and/or have an aversion to borrowing.
- A lack of understanding of the benefits of taking discounts.
With those issues on the table, let’s look at the value of prompt payment discounts. First, we should understand that not every supplier offers prompt payment discounts. We will come back to this later, but for now, let’s just assume that XYZ Vendor does provide standard trade terms of 2% 10 days/net 30 days. This means the supplier is willing to reduce the invoice by 2% if you pay within in the first 10 days, otherwise you should pay in 30 days. How should you analyze this deal? The most appropriate way to look at this is that the customer is saving 2% over the 20 additional days that would be required to pay on 30-day terms. So, we would save $20 by paying in 10 days. This does not sound like much (and there could be processing problems that might make early payment a challenging task). However, what we find when we state the problem a bit differently is that the implied interest rate is 36.50%. Here is the calculation: 2% x 365days/20days. WOW!! Why would you not try to take advantage of such a good deal?
Many business owners just do not understand the math behind supplier discounts. But now that the opportunity cost has been explained, let’s discuss how you would go about saving money thru making prompt payments. I recommend you begin by scheduling all your suppliers, starting with the greatest dollars expended each year. Then determine how many suppliers offer prompt payment discounts. Usually vendor invoices will list the trade terms somewhere on the face. If a supplier does not offer discounts, it never hurts to ask. Start taking the discounts, and if need be, borrow on a line of credit at say 6.5% to save net 30% per year.
If you would like to receive an Excel spreadsheet with all the calculations for various discount levels and terms, please e-mail me at email@example.com. Be sure to include your name and the name of your business. Thanks for reading.