When I was in the remodeling business, the lumberyard I did the most business with offered a 2% discount for early payment on its monthly statement. I always tried to take advantage of it, but when I didn’t have the cash flow, I didn’t lose any sleep over missing out on the discount. After all, it was only 2%.
If I knew then what I know now, I would have done whatever I had to do to get the discount. Best case would have been to manage cash flow better so that I always had enough money in the bank to make payment by the discount date. But would it have made sense to borrow money to earn a measly 2% discount?
You bet it would. Still does. Let’s look at an example to see why.
Annualize the Discount
Let’s say the vendor offers a 2% discount if you pay by the 10th of the month; otherwise, the full amount is due by the 30th. If your monthly purchases total, say, $10,000, and you pay early, you would pay $9,800 (see chart below). One way to look at it is that you’ve earned $200 for the 20 days you could have held the $9,800 (20 days is the difference between the 10th and 30th of the month).
This certainly makes sense if you have the money, but if you had to borrow the $9,800 at, say, 20% interest, would that still make sense? Would it make sense to pay 20% to save 2%? The answer is yes—with some very important caveats that we’ll get to in a minute—and here’s why: the 2% is a 20-day rate and the 20% is an annual rate. To compare apples to apples, we need to figure out how much the “loan” costs you per day.
The Discount Timeline
Most loan interest rates are expressed as an annual percentage rate, or APR. If you took a $9,800 loan at 20% APR to get the lumberyard’s discount, and if you didn’t repay the loan for 365 days, you’d owe an extra $1,960. To compare that to the $200 we save with the discount, we need to figure out how much the 20% APR amounts to per day:
Now let’s revisit our scenario. The lumberyard invoice arrives at the first of the month offering a 2% discount if you pay by the 10th of the month. You don’t have enough cash to pay early and reap the discount, but you expect a number of clients to pay their bills by the end of the month. So you borrow $9,800 and pay on the 10th, and 20 days later, on the 30th, after client checks have come in, you repay the loan. Did you save any money by borrowing to pay early? Let’s do the math:
Obviously timely repayment of the loan is critical here. In our example, you only held the loan for 20 days, not 365. Had you not paid it off for another 17 days or so ($92.60 savings ÷ $5.37 daily interest = 17.24 days), you would have barely broken even on the early payment discount.
What if enough client checks came in to enable you to repay the loan after just one day? The $9,800 loan would have cost only $5.37, for a net savings of $194.63 ($200 discount - $5.37 daily interest).
This example, while a bit extreme, does make it clear that taking advantage of the discount makes sense. But applying for a loan every month isn’t a realistic way to get that discount. Fortunately, there are alternatives—some good, some not so good.
One not-so-good alternative is a credit card. Not many vendors will accept credit card payment to settle a monthly statement, but even if they did, it’s a dangerous game to play. Credit cards are complicated: Interest rates can be fixed or variable; most impose a late payment fee; and the start and end dates of the billing cycle may not align with your vendor’s discount schedule.
Some companies issue credit cards to employees to make direct purchases, but that makes sense only if you pay the credit card bill in full and on time every month. Otherwise, late payment fees and compound interest (if you make only the “minimum payment”) will add up quickly.
Some vendors offer a discount for early payment. In this example, full payment of $10,000 is due in 30 days, but if you pay within 10 days, you pay $9,800, saving $200, or 2%.
Line of Credit
The best solution is to manage cash flow so that you always have enough money in the bank to pay your bills without having to borrow. That means staying ahead on billing; chasing down slow-paying clients; and, in the larger picture, managing sales, estimating, and production closely so that you hit your gross profit targets.
But it doesn’t hurt to have a back-up plan, and a good one is a line of credit. Unlike a regular loan, which is a lump sum on which you pay interest from Day One, a line of credit is a reserve of money that is available for you to borrow as needed, up to a specified maximum. You pay interest on only the amount you borrow, and when you pay back the money, the line of credit is replenished.
It’s more complicated than that—a line of credit can be secured or unsecured and, like a credit card, using “minimum payments” to repay it can be costly—but it’s worth looking into to bridge unforeseen gaps in cash flow or to enable you to take advantage of something like an early payment discount. Most banks offer personal and business lines of credit, but credit worthiness is critical to being approved, so it’s important to apply for a line of credit before you actually need it.
Long story short, take the discount, but use money in your business checking account to make the early payment. Next best is to get yourself a line of credit, and be sure you can pay it off in time to maximize your discount savings. And if your vendors don’t offer an early payment discount, maybe it’s time to ask them about it. Depending on how much business you do with them and your credit history, you may be able to strike a deal.
At a 20% APR (annual percentage rate), interest on $9,800 is $1,960 per year ($9,800 x 0.20), which is $5.37 per day ($1,960 ÷ 365). If you borrow money to pay early, and pay back the loan in 20 days, you still save $92.60.
Thanks to Leslie Shiner (shinergroup.com) who, in a presentation at an industry event many years ago, first introduced me to this way of doing the math on vendor discounts.