Should You Take Advantage of Prompt-Pay Discounts?
For most companies today, cash flow is the name of the game. To help keep cash flowing into their coffers more smoothly and predictably, many companies offer what are known as prompt-pay discounts -- incentives to encourage customers to pay their invoices not just on time, but early.
Prompt-pay discounts are often referred to as “2/10, net 30” discounts. Translation: If the payment amount is due in the typical 30 days, you’d receive a 2 percent discount if you pay it in 10 days instead of 30.
If your company is offered such a discount, should you take it? There’s a helpful formula accounting professionals use to help determine the effective annual return of taking prompt-pay discounts:
(Amount of discount/discounted price) multiplied by (number of days in the year/number of days paid early)
Let’s say you have a $1,000 invoice. You’d receive a $20 discount if you paid it within 10 days, so the math would look like this:
(2/98) multiplied by (360*/20) equals 0.367, or 36.7 percent
According to this formula, taking the 2/10, net 30 discount is the equivalent of an effective annual return of more than 36 percent. So the answer is yes, you should absolutely take the discount -- right?
Not so fast. Before deciding on your final answer, you need to perform a cost-benefit analysis that compares the savings that can be realized to the opportunity cost of not having the use of this cash yourself for up to 20 days.
The first thing you have to find out is whether your cash flow will allow you to pay early enough to take the discount. To determine this, take a close look at your cash cycle -- the timing of the monthly flows of cash into and out of your business.
Unless you’re sitting on enough cash to cover at least one month’s worth of business expenses in advance, you’ll need to accelerate your cash disbursements by at least one month to take advantage of the discount. However, this can be challenging even for companies with strong cash flow. Another option is to tap funds from current investments to pay invoices early, although this may involve sacrificing interest, dividend, or capital gains opportunities.
A third option is borrowing the money you need to make payments early. While this would not affect current working capital or investment opportunities, there is obviously a cost involved in borrowing funds. So the question becomes: Are the savings that can be realized via a prompt-pay discount greater or less than your cost of funds?
The best way to determine this is to crunch the numbers and see the impact of paying a year’s worth of supplier invoices early via a 2/10, net 30 discount:
- Annual invoice total: $1 million
- Total annual discounts: $20,000 (1,000,000 multiplied by 0.02, or 2 percent)
- Average additional funds needed to fund an additional 20 days of cash flow each month: $54,795**
The net annual savings or loss would be the difference between the total annual discounts and the cost of borrowing the funds needed to take advantage of them. If your cost of funds (e.g., interest rate) is 7 percent, the net savings would be as follows:
- Cost of funds: $3,836 ($54,795 multiplied by 0.07, or 7 percent)
- Net savings: $16,164
As this example shows, in a low-interest-rate environment like today’s, it usually makes financial sense to borrow the money necessary to take advantage of prompt-pay discounts. The most efficient way to borrow money for this purpose is via a bank revolving line of credit, which can easily be tapped and repaid at the owner’s discretion.
Doing so, however, requires a degree of financial discipline with regard to using the credit line. Most banks require lines to be paid down in full at least once a year, so be sure to discuss this with your banker before implementing this strategy.
* In this formula, accountants use 360 days in a year instead of 365.
** ($1,000,000/365) multiplied by 20 equals $54,795.
Don Sadler is a freelance writer specializing in business and finance. Reach him at don@donsadlerwriter.com.
