Lesson 5.2 35 min
Credit terms and early-payment discounts
How to read terms like 2/10 net 30, the rate they imply, and when to pay early or offer a discount.
Trade credit is the most common short-term finance a small business uses. A supplier sends goods and an invoice, and the buyer pays later. The terms on the invoice set the price of that delay.
Reading the terms
"Net 30" means the full amount is due in 30 days. "2/10 net 30" means a 2% discount if the invoice is paid within 10 days, and the full amount due on day 30. The buyer chooses between paying early at a discount or keeping the cash for 20 more days at full price.
The cost of passing up a discount
Take a $20,000 invoice on 2/10 net 30. Paying on day 10 costs $19,600.00. Paying on day 30 costs $20,000. The extra $400.00 is the price of borrowing $19,600.00 for 20 days. That rate for the period is
Rate for the period = Discount ÷ (1 − Discount) = 2% ÷ 98% = 2.04%
A 20-day rate is not an annual rate. There are 365 ÷ 20 = 18.25 such periods in a year, so the annualised rate is 2.04% × 18.25 = 37.24%. If the rate is compounded, which is the effective annual rate from lesson 4.1, it is 44.59%.
| Terms | Rate for the period | Annualised |
|---|---|---|
| 1/10 net 30 | 1.01% | 18.43% |
| 2/10 net 30 | 2.04% | 37.24% |
| 2/10 net 60 | 2.04% | 14.90% |
A rate of this size is much higher than most credit lines. Unless the business has no other source of cash, paying within the discount period is almost always the better choice. The comparison to make is the annualised rate of the terms against the rate on the cheapest funds available.
Putting it in dollars
| $ | |
|---|---|
| Invoice amount, due day 30 | 20,000 |
| Amount if paid on day 10 | 19,600.00 |
| Discount given up by waiting 20 more days | 400.00 |
| Cost of borrowing $19,600 for 20 days at 9% | 96.66 |
| Net saving from paying on day 10 | 303.34 |
Alder borrows on its line at 9% to take the discount. Borrowing $19,600.00 for 20 days costs $96.66 and saves $400.00, a net gain of $303.34 on one invoice.
The seller's side
The discount that is cheap for the buyer is a cost to the seller, which gets 98 cents on every dollar of sales that take it. The seller gives it to get cash sooner. The test is whether the interest saved on the cash released exceeds the discount given. The break-even is the discount given divided by the cash released: if the seller's alternative cost of funds is below that rate, the discount loses money.
Two points apply to both sides. First, terms are negotiable, and a buyer with a good record can sometimes get longer terms without discount. Second, late payment has its own costs: a loss of early-pay discounts, a damaged supplier relationship, and in some places statutory interest on overdue invoices. Check the rules where you operate.
Worked case
Alder offers a discount to its own customers
Alder's customers currently pay in about 60 days. It considers offering 2/10 net 30 to speed that up. Suppose 40% of revenue, which is $350,400, moves to the discount and is paid on day 10 instead of day 60.
| $ | |
|---|---|
| Sales that move to the discount, 40% of revenue | 350,400 |
| Discounts given, 2% | (7,008.00) |
| Receivables released, 50 fewer days | 48,000 |
| Interest saved on that cash at 9% | 4,320.00 |
| Net effect | (2,688.00) |
The discount costs $7,008.00. Receivables fall by 50 days of those sales, $48,000, and at Alder's 9% line rate that saves $4,320.00 in interest. The net effect is a loss of $2,688.00 a year. The discount would pay for itself only if the cash it releases would otherwise cost more than 14.6% a year.
For a business with a credit line at 9%, the offer loses money. For one that cannot borrow, because it is close to the limit of its line or has none, cash that arrives sooner has a value well above 9% and the answer changes. The decision turns on what the cash is worth to the business in the next two months, so the owner needs the forecast in lesson 5.3. A shorter alternative is to enforce the current terms: collecting 60-day customers at 45 days releases cash at no discount cost, though it risks losing some of them.
Template
Credit terms workbook
A buyer sheet that takes the discount percentage, the discount days and the net days and returns the rate for the period, the annualised and compounded rates, and the dollar gain from paying early against a credit line rate. A seller sheet works out the net effect of offering a discount and the break-even financing rate. Both cases are loaded.
The full working file, 5-2-credit-terms.xlsx, is in the Accounting and Finance Toolkit, Complete Track 1. The lesson above teaches the method and shows the worked numbers, so you can build it yourself in any spreadsheet.
Exercises
Work these, then open the answers
Find the annualised rate that 3/10 net 45 implies.
Answer
3% ÷ 97% = 3.09% for the period, which is 35 days. 3.09% × 365 ÷ 35 = 32.25%.
A supplier offers 1/10 net 30 on a $20,000 invoice. Alder's credit line costs 9%. Should it take the discount?
Answer
The terms imply 18.43% annualised, more than 9%, so yes, as long as the line has room. Waiting 20 days costs $200 on $19,800 of borrowing, while the line charges $97.64 for the same 20 days.
A supplier on 2/10 net 60 offers more time. How does the implied rate compare with 2/10 net 30?
Answer
With 50 days gained, the annualised rate is 14.90%, against 37.24% at net 30. A longer net period lowers the rate, because the cost of 2% is spread over more days.
Check
4 questions
Sources
Sources
- Principles of Accounting, Volume 1: Financial Accounting, OpenStax, Rice University
- Principles of Finance, OpenStax, Rice University