How do I determine if it is profitable to pay a 1%-10 day cash
discount for material that we sell for a 2% gross margin?

I am paid in 60 days. I borrow against a line-of-credit to pay for the
material.

I get 75% of the 2% gross margin, and the loan costs come out of this
share.

My current loan rate is 4.25%. 

If I don’t take the 1% discount, I must pay Net 30 days. 

I don’t need to include other costs. 

A good answer includes calculations showing why it is profitable or
not, will allow me to apply different future rates, and is written to
a non-financial person’s understanding.

Everyman –

Your terms are commonly referred to as 1%/10, net 30.  This earns you
an implied interest rate of 1% for paying 20 days early.  If you’re
continually using such a discount, you’re effectively “turning” that
money 18.25 times per year (365/20).  This earns an annualized
interest rate of 1.01^18.25 (1.01 multiplied by itself 18.25 times) =
1.1991 or 19.9% interest.

Since it’s far higher than your annual interest rate on the loan, you
absolutely want to borrow to finance it.


AN ALTERNATE VIEW OF TRADE CREDIT
-----------------------------------

There is another way to look at your costs: for every $100 (or 100
pounds or 100 francs) that you sell, it is costing you 0.0425 * $100 *
60/365 to provide your customers trade credit of 60 days – or $0.70. 
Will you save more than 70 cents in paying a $100 supplier’s bill?  In
this simple example, you’d save $1 every 20 days – actually saving $3
if bills are cycled continuously.

Note that if you shorten your own trade credit to 45 days (or
eventually 30 days), your financing costs drop.

You may be interested in seeing several other examples of prompt
payment discounts from a recent Google Answers question:
http://answers.google.com/answers/main?cmd=threadview&id=220161

There’s no Google search for this answer; instead I’ve relied on
professional financial experience.

Best regards,

Omnivorous-GA

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Request for Answer Clarification by everyman-ga on 15 Jul 2003 15:29 PDT

Thanks for the quick answer, but can you 'dumb this down' a little?

I'm only billed once a month, so I don't think I'd be earning the
effective 19.9% (would it be 12.12%?).

I'm also not following how you came up with "In this simple example,
you’d save $1 every 20 days – actually saving $3 if bills are cycled
continuously." I'm working on a monthly billing basis - both for
receiving invoices from vendors and sending invoices to customers.

Does this mean that if I only took advantage of the 1% cash discount
one time, that I would net $0.30 profit per $100 sale just on the
difference of my vendor's terms and my credit terms to my customer?

Shortening our trade cycle in this business environment is not
currently an option.

Thanks for your patience. I hope I'm stating my question clearly.

---

Clarification of Answer by omnivorous-ga on 15 Jul 2003 16:00 PDT

Everyman --

Calculations of effective annual interest rate assume that cash is
continually re-invested at the interest rate.  It could well be the
case if you have multiple suppliers offering 1%/10, net 30 terms and
you’re paying bills weekly.

Still, if you enjoy the discount when paying bills only once each
month, you’re enjoying 1.01^12 (1.01 multiplied by itself 12 times). 
That comes out to 12.7% thanks to the miracles of compounding.

You are precisely correct in the conclusion that using financing
differences are giving you $0.30 per $100 sale due to difference in
vendor terms and your loan.  This is not a large return and a
receivables write-off of only 1% would more than wipe out that profit.

As I’m sure you know, a higher interest rate will wipe out this
profit.  So too would extension of payment time by customers; rapid
movement in the price of the product; inventory spoilage; product
returns and a host of other business risks.

Thank you for the clarification here and please let me know if the
answer is still unclear.

Best regards,

Omnivorous-GA

Thank you for the great answers. I appreciate that you made it clear
it was okay for me to keep asking for clarification.

I now realize that the A/P question is distinctly different from the
A/R part of the question. I will think this through, and will probably
post a new question about the A/R portion of my issue.