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Intro to "Calculate the Annual Effective Rate of your Prompt Payment Discount"

 

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Calculate the Annual Effective Rate of your Prompt Payment Discount Say you have access to a discount by paying your supplier earlier, but you hesitate? No matter what is the reason, it is wise to calculate the annual rate to evaluate your opportunity cost.

A prompt payment discount or prompt-pay discount is an opportunity to invest in the company by injecting an amount prematurely in order to get a return: the discount. However, this investment could deprive other sectors. Annualizing the prompt-pay rate will help to compare its return with your cost of capital, which will tell you if it's more profitable to invest in the discount allowance than elsewhere in the business.

On the other hand, the grace period offered by the supplier is a source of financing. You could skip the discount allowance and pay the vendor later; this practice is a way to loan money elsewhere than from banks. If this option is taken, you will pay a higher bill since the discount would be eliminated, which is similar to say that you would pay interest on a loan. It is then important to compare the supplier's cost of interest with the banks to see if it's reasonable to borrow from the supplier.

Either way, the annual rate in the case of return on investment or cost of interest is the same.

The sales terms are expressed with a rate and a delay, such as "2% 10 days net 30 days". In this example, you have access to 2% discount if you pay in 10 days, or else you have to pay the total invoice in 30 days. In terms of investment, this is a return of 2.04% for an amount invested 20 days earlier. In terms of credit, this means that you pay more than 2.04% interests for a loan of 20 days if you skip the early payment discount. It is then interesting to annualize the discount rate and compare it with other possible investment in the business or interest rate offered by banks.

In our example below, the sales term "2% 10 days net 30 days" gives an annualized rate of 36.7% and an effective annual rate of 43.9% if the interests are capitalized every 20 days through the whole year.

Note: example with 100$ and 2% 10 days net 30 days:

100$ - 2% discount = 98$
100$ / 98$ -1 = 2.04% for 20 days (30 days – 10 days)
Annual : 2.04% * 360/20 = 36.7%

If your objective is to optimize your investment in the business, an annual discount rate higher than your cost of capital means it is a good opportunity, because the discount ends up being more profitable than investing in other sector of the business. On the other side, a lower discount annual rate shows that it is better to invest elsewhere in the company, in sectors that would give you a better return. The annualized rate of 36.7% in our example is normally a great rate of return, which demonstrates that the discount is a good option. With such a rate, you can even borrow at an interest cost and obtain a net return higher than your cost of capital.

If you are looking to optimize your financing, and the annual interest rate from the supplier's credit is higher than what banks offer, it is preferable to borrow from banks instead. This could also mean that it is preferable to borrow from that bank and pay the supplier early to get the discount and avoid the high cost of interest from the supplier. If it is the opposite and the banks' interest is higher, your supplier appears to be a better source of financing than the bank, so the prompt payment discount might not be the optimal option. In our example, 36.7% is normally a high interest rate, in that case it is better to take the prompt payment discount and borrow from banks.

No matter what is your priority between optimizing your investment or your financing, the right decision on the prompt payment often ends up satisfying both options. In our example, 36.7% is a great return on investment and a high loan interest rate, so taking the discount, and even borrowing at cost to do so, satisfies both objectives. You can annualize the discount annual rate from your supplier by using this calculator and then judge on your opportunity.

 

Try the Calculate the Annual Effective Rate of your Prompt Payment Discount Calculator >

 
 
 
 
Numbers in our calculators are rounded to two decimals.
The same calculations made in an Excel spreadsheet may differ slightly.

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