Tuesday, December 31, 2002

Payment discount factor

Q: My vendors offer payment discounts, depending on when I make payment. How do I determine which to take advantage of?

A: Each day decisions must be made on what bills to pay. Something that should always be considered is the cost of not paying an invoice in time to take advantage of an available discount. A lost discount is an interest charge.

To measure the cost of missing a discount, the annualized interest rate must be calculated. The formula to determine the annualized interest rate of missing a discount is as follows:
Annualize interest rate =
Discount % / (100% - Discount%)
X 365 days / Total credit period - Discount period
Assuming payment terms of 2% 10 days/ Net 30 days, the calculation would be as follows:

2% / (100% - 2%) X 365 days / (30 days - 10 days)

= 37.2% Annualized Interest Rate

Once the annualized interest rate for an invoice has been determined, it can be compared to the cost of other financing or the return available from alternative uses of cash on hand. An intelligent decision can then be made on the source and timing of payment.

The calculations above are based on adhering strictly to the supplier’s payment terms. You can reduce the impact of a lost discount by delaying payment beyond the “net” period set by the creditor. However, not abiding by the stated credit terms may present other risks and costs.

Don Clayback is V.P. of Networks for The MED Group. Reach him at 716-835-1728.