The most expensive loan hardly anyone notices
If you settle an invoice with a cash discount offer only at the payment term, you take out a loan without noticing. The supplier finances the time between the discount period and the payment term and charges a price for it: the discount you forgo. This form of financing is called supplier credit or trade credit. It needs no application and no credit check. That is exactly why it is often underestimated.
The exact formula
To compare supplier credit with a bank loan, you convert it into an annual rate. The 360-day banking year is customary:
Effective annual rate = discount rate / (100 − discount rate) × 360 / (payment term − discount period) × 100
The formula has two parts. The first, discount rate / (100 − discount rate), is the interest for the credit period. With a 2% discount you pay €2 for every €98 of payable amount for the extension, i.e. 2.04%. The second part, 360 / credit days, scales this up to a year. With a credit period of 20 days, the period fits into the year 18 times.
For a 2% discount, a 10-day discount period and a 30-day term this gives 2 / 98 × 18 × 100 = 36.73% per year.
The rule of thumb and its error
Many textbooks and conversations use a simplified formula:
Rule of thumb = discount rate × 360 / (payment term − discount period)
In the example it gives 36%. The difference from the exact formula arises because the rule of thumb relates the discount to the full invoice amount, although you only put up 98% when paying with the discount. With small discount rates the error is small; at 3% it already grows to several percentage points. For the decision between discount and credit line the rule of thumb is almost always enough, because the gap to the bank rate is usually large.
Table: how expensive skipping the discount is
The following table shows the effective annual rate (exact formula, 360 days) for typical payment terms:
| Discount | 10 / 30 days | 14 / 30 days | 10 / 60 days | 14 / 60 days |
|---|---|---|---|---|
| 1% | 18.18% | 22.73% | 7.27% | 7.91% |
| 2% | 36.73% | 45.92% | 14.69% | 15.97% |
| 3% | 55.67% | 69.59% | 22.27% | 24.20% |
Two things stand out. First, the shorter the credit period, the more expensive it is to skip the discount. 2% for 16 days is worth much more than 2% for 50 days. Second, with long payment terms the discount's annual rate can fall below an expensive overdraft rate. Then the answer is no longer clear-cut.
Is financing through the credit line worth it?
The decision rule: if the effective discount rate is above the rate of your credit line or overdraft, take the discount and finance the early payment through the account if necessary. If it is below, pay at the due date.
Example 1: invoice €4,760 gross, 2% within 10 days, net 30 days, credit line rate 12%. The discount is €95.20, the payable amount €4,664.80. Financing for 20 days costs €4,664.80 × 12% × 20 / 360 = €31.10. That leaves an advantage of €64.10.
Example 2: invoice €1,190 gross, 2% within 10 days, net 60 days, overdraft rate 16%. The discount is €23.80. Financing €1,166.20 for 50 days costs €25.92. Here financing is more expensive than the discount. Paying early only makes sense if the money is in the account anyway.
What if the money is already there?
If you have enough funds, the benchmark is not the loan rate but what the money would otherwise earn, for example in a savings account. That interest is almost always far below the discount's annual rate. Businesses with cash on hand should therefore practically always take the discount.
The seller's view
For the seller the same number is a cost. Granting 2% at 10 / 30 days means paying the equivalent of more than 36% interest for receiving the money 20 days earlier. That can still make sense, for example to reduce the risk of non-payment or avoid a cash squeeze. But it should be priced in.
You can try out your own terms in the cash discount calculator. The chart shows how the annual rate changes with the credit period. The basics are in the cash discount guide.