When vendors offer (cash) discounts for early payment, it is important to do the maths to ascertain whether it is worthwhile. Whilst a 3% discount may seem trivial, it can represent significant savings.
The $ amount saved should be seen as ‘interest’ paid to the retailer (by the vendor) for the ‘loan’ which amounts to the net amount paid by the retailer – for a certain number of days.
A retailer buys merchandise with a list price of $1000. If the term is offered as 3/10 n/30, it means that the full amount is payable in 30 days from the invoice date, but 3% discount is offered if paid within 10 days.
Let’s assume that the invoice is dated 5 June – which means the full amount is due 30 days later on the 5th July. If, however, it is paid by the 15th of June, the retailer is entitled to a 3% discount. The vendor is offering the retailer 3% discount to pay the account 20 days earlier than usual. [Because the vendor gets the money 20 days earlier, they will pay interest on being able to use the money for the 20 days.]
It is calculated as follows (for the above example):
(Amount Saved/ Net Amount Paid) x (365/No of Days Saved)
Amount Saved 3% x $1000 = $30
Net Amount Paid $1000 – $30 = $970
No of Days Saved 20 days
Substituting in the formula, the ‘interest paid’ by the vendor:
($30/$970) x (365/20) = 56.4%
The annualised rate of interest (i.e. saving to the retailer) is 56% – which is a great deal better than leaving the money in the bank for an extra 20 days. [Where it would have earned say 10% per annum; which equates to about $5.48 for the 20 days as opposed to $30 as per above.]
These numbers are realistic and the situation often presents itself. This means that it is usually a good deal to take the early payment option. But please note that there is an assumption that this the best use of funds. Retailers must consider alternative uses and cash-flow impacts as this illustration simply compares the early payment option with the alternative of a bank deposit.