The rate is the easy half. The half that decides it is what the shorter payment terms do to net debt, and who in the building is measured on which.
Terms of 2/10 net 60 mean paying two per cent less if you pay on day 10 instead of day 60. Not taking the discount is borrowing the money from the supplier for 50 days, and the annualised cost of that loan is 14.8980 per cent. Against a revolver at 4.50 per cent, taking it is worth 5,471,890.41 a year.
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Two per cent buys 50 days — day 10 to day 60. The discount is taken on the invoice, so the amount actually financed is 98 per cent of it: 2 / 98 × 365 / 50 = 14.8980 per cent.
That is the number to compare with the cost of funding, and it is the reason the answer is usually yes. On this company the drawn revolver costs 4.50 per cent and the term loan 4.75 per cent; even the overdraft rate of 5.50 per cent is a fraction of it.
| Amount | |
|---|---|
| Purchases carrying the offer — 40 per cent of cost of goods sold | 392,000,000.00 |
| Discount captured at two per cent | 7,840,000.00 |
| Cost of funding 50 days on the revolver at 4.50 per cent | −2,368,109.59 |
| Net gain, per year | 5,471,890.41 |
| Average cash tied up | 52,624,657.53 |
Paying on day 10 instead of day 60 shortens days payable outstanding on those invoices, so the cash conversion cycle lengthens and reported net debt rises by the average balance no longer owed.
| Before | After taking the discount | |
|---|---|---|
| Net debt on reported cash | 336,000,000.00 | 388,624,657.53 |
| Leverage on that reading | 2.0000× | 2.3132× |
| Cost in turns | 0.3132 |
So the honest answer has two parts. The discount is worth 5,471,890.41 a year and is worth taking at any funding cost below 14.8980 per cent — unless the 0.3132 turns matter, which they do only if a covenant is close. On this company the binding test has 0.6310 turns of headroom on the facility's own definition of cash, so the trade is available; on a company with half a turn, it is not.
Nobody is measured on it. The payables team is measured on days payable outstanding, and taking the discount makes their number worse. The treasurer is measured on cash and on covenant headroom, and does not see the invoice terms. The line is worth 5,471,890.41 a year and it sits between two people, each of whom is doing their job.
That is also why the fix is not a policy but an arithmetic one: price every early-payment offer in the same unit as the funding it replaces, and put the answer in front of whoever owns the funding cost. The generalisation is dynamic discounting — a discount priced on the days actually saved rather than a fixed two per cent — and it is the same computation with the rate solved for instead of assumed.
Take the terms off the largest twenty suppliers, annualise each offer with d / (1 − d) × 365 / (net days − discount days), and compare the result with your marginal cost of funds. Then compute what taking them all does to net debt, and check it against the headroom on the covenant's own definition of cash before deciding. Two numbers, and the second one is the one that gets forgotten.
Almost always. Its annualised cost is 2 / 98 × 365 / 50 = 14.8980 per cent, far above any ordinary funding cost. On this company taking it is worth 5,471,890.41 a year net of financing at 4.50 per cent.
d / (1 − d) × 365 / (net days − discount days). For 2/10 net 60 that is 2 / 98 × 365 / 50 = 14.8980 per cent.
It raises reported net debt by the average cash tied up — 52,624,657.53 here — which is 0.3132 turns of leverage, taking the reported ratio from 2.0000× to 2.3132×.
This article is one calculation from Treasury Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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