One common way companies encourage their customers to pay early is to offer them a discount. In the world of financial reporting, when a discount is offered, a customer may see a term such as “2/10 net 30” or “3/10 net 60” at the top of its bill. “2/10 net 30” means that the customer can take a 2 percent discount if it pays the bill within 10 days.
Otherwise, it must pay the bill in full within 30 days. “3/10 net 60” means that if the customer pays the bill within 10 days, it can take a 3 percent discount; otherwise, it must pay the bill in full within 60 days.
Taking advantage of this discount saves customers money, but if a customer doesn't have enough cash to take advantage of the discount, it needs to decide whether to use its credit line to do so. Comparing the interest saved by taking the discount with the interest a company must pay to borrow money can help the company decide whether using credit to get the discount is a wise decision.
How to calculate the annual interest rate
The formula for calculating the annual interest rate is:
([% discount] ÷[100 – % discount]) x (360 ÷Number of days paid early) = Annual interest rate
For terms of 2/10 net 30
You first must calculate the number of days that the company would be paying the bill early. In this case, it's paying the bill in 10 days instead of 30, which means it's paying the bill 20 days earlier than the terms require. Now calculate the interest rate, using the annual interest rate formula:
(2 [% discount] ÷98 [100 – 2]) x (360 ÷20 [Number of days paid early]) = 36.73%
That percentage is much higher than the interest rate the company may have to pay if it needs to use a credit line to meet cash-flow requirements, so taking advantage of the discount makes sense.
For example, if a company has a bill for $100,000 and takes advantage of a 2 percent discount, it has to pay only $98,000, and it saves $2,000. Even if it must borrow the $98,000 at an annual rate of 10 percent, which would cost about $544 for 20 days, it still saves money.
For terms of 3/10 net 60
First, find the number of days the company would be paying the bill early. In this case, it's paying the bill within 10 days, which means it's paying 50 days earlier than the terms require. Next, calculate the interest rate, using this formula:
(3 [% discount] ÷97 [100 – 3]) x (360 ÷50 [Number of days paid early]) = 22.27%
Paying 50 days earlier gives the company an annual interest rate of 22.27 percent, which is likely higher than the interest rate it would have to pay if it needed to use a credit line to meet cash-flow requirements. But the interest rate isn't nearly as good as the terms of 2/10 net 30.
A company with 3/10 net 60 terms will probably still choose to take the discount, as long as the cost of its credit lines carries an interest rate that's lower than the rate that's available with these terms.
What do the numbers mean?
For most companies, taking advantage of these discounts makes sense as long as the annual interest rate calculated using this formula is higher than the one they must pay if they borrow money to pay the bill early.
This becomes a big issue for companies because, unless their inventory turns over very rapidly, 10 days probably isn't enough time to sell all the inventory purchased before they must pay the bill early. Their cash would come not from sales but, more likely, from borrowing.
If cash flow is tight, a company has to borrow funds using its credit line to take advantage of the discount. For example, if the company buys $100,000 in goods to be sold at terms of 2/10 net 30, it can save $2,000 by paying within 10 days.
If the company hasn't sold all the goods, it has to borrow the $100,000 for 20 days, which wouldn't be necessary if it didn't try to take advantage of the discount. You can assume that the annual interest on the company's credit line is 9 percent. Does it make sense to borrow the money?
The company would need to pay the additional interest on the amount borrowed only for 20 additional days (because that's the number of days the company must pay the bill early). Calculating the annual interest of 9 percent of $100,000 equals $9,000, or $25 per day.
Borrowing that money would cost an additional $500 ($25 times 20 days). So even though the company must borrow the money to pay the bill early, the $2,000 discount would still save it $1,500 more than the $500 interest cost involved in borrowing the money.
