As a business owner, you know all too well that there are times when there is not enough cash to go around. This can happen for many reasons, but for some, it is simply a reflection of the gap between merchandise going out and payments on invoices coming in. Banks aren’t always able to provide enough working capital either, even if a company has good financials.
As a result business owners find themselves creating alternative solutions to get money flowing again; like adjusting the terms of the invoice or offering discounts to get paid before the invoice is due so that they don’t have to borrow from lenders. Usually, this discount is expressed as 2% /10 net 30. Simply stated, you will accept 2% less of the invoice amount if your client pays within ten days.
While an ‘early pay discount’ may sound good, it can cause a significant loss in funds over time.
Let’s look at the math.
Say that we sell you a box of widgets for $10,000.
Once you receive the widgets, I will issue you an invoice for $10,000 that is due within 30 days.
In that invoice, I state to you that I will accept a 2% discount if you pay that invoice within 10 days.
Effectively, I am saying to you that if you accelerate my cash flow by 20 days (paying early), then I will accept $9,800 as full and final payment. (Reflecting the 2% discount.)
Sounds like a win-win right?
Well consider this:
If your customer chooses to take advantage of the discount noted above, you now have use of the amount of $9,800 for an additional 20 days, which in turn reduces the funding needed from lenders by the same amount.
But let’s say that you’re using the same numbers in this next math equation. Except that we’re going to take the $200 ‘discount’ and break it down in reverse to show you how much the equivalent of that would be as an ‘interest percentage’IF you would have gotten a loan to get you through that 20 day period.
Interest Rate for 20 days: = $200 (identified earlier as 2%)
Annual Interest Rate = (2% /20 days) x 365 days in a year = 36.5%
That would be the equivalent of paying 36% interest on the $9,800!
Shocking isn’t it?!
From that angle, it is easy to see that if a businesscould borrowat a rate which is less than the calculated annual interest rate (shown above), then it would be preferable to do so rather than offer the customer the early payment discount, right?