Discounts for early payment

CL writes: I own and run a small company and I have always paid creditors at the last possible moment but generally within 60 days to maximise my cash resources. I have recently been offered a 2% early-payment discount if I settle within 20 days. I am tempted as the cost of borrowing has fallen in recent times. Is there a simple rule I can apply to decide when to take a discount and pay early?

Answer

In an ideal world you should take the discount and pay early. If you normally pay a supplier after 60 days you are effectively borrowing the money from your supplier at a rate of interest that would be the annual equivalent of the discount. If you work out the annual cost of the discount you have been offered and find it is higher than either the cost of your overdraft rate of interest or the opportunity cost of the credit interest of funds in your bank account, it would be advantageous to borrow more by way of overdraft or loan to take advantage of the discount. To work out whether to take the discount do this sum: discount offered divided by 100 minus the discount offered (in this case, 2 divided by 98). Multiply this by 365 divided by current payment period minus discount period, in this case 40 (60-20). Here, the result, 18.6%, is probably greater than your actual cost of funds, so you should accept the discount.