Many suppliers offer an incentive called an early payment discount to encourage buyers to pay their invoices faster. This discount allows the buyer to deduct a small percentage from the total owed if they pay within a specified time period, such as 10 days. The terms are often stated like “2/10 net 30” which means you can deduct 2% if paid in 10 days, with the full amount due in 30 days.
While taking the discount requires paying sooner than the full net term, there can be a significant return on that investment of paying early. That’s because the discount percentage translates into an extremely high annualized rate of return. Understanding this ROI is important for businesses to evaluate whether it makes sense to take advantage of early payment discounts when offered.
What’s an Early Payment Discount?
An early payment discount is an incentive offered by suppliers to encourage buyers to pay invoices faster than the full net term. The discount allows the buyer to deduct a small percentage from the total amount owed if they submit payment within a specified time period, such as 10 days.
Early Payment Discount Example
Say you receive an invoice for $10,000 with terms of 2/10 net 30. If you pay the full $10,000 at the very end of the 30 day period, no discount applies. However, if you pay within the first 10 days, you can deduct 2% which is $200. So you would only pay $9,800 instead of the full $10,000.
The key question is – what rate of return did you earn on that $200 savings for paying 20 days earlier than was required? This is where understanding the time value of money concept is important.
To calculate, we treat the $200 as the interest earned. The $9,800 you had to pay upfront is considered the principal invested for those 20 days until the full amount came due. Plugging those numbers into the formula:
ROI = Interest / Principal
= $200 / $9,800
= 0.0204 or 2.04%
So you earned a 2.04% return just for paying that 20 days sooner. That may not seem hugely impressive at first glance.
However, we have to annualize that return based on the number of days it was invested. There are 365 days in a year, so:
Annualized ROI = (1 + 0.0204)^(365/20) – 1 = 45.67%
By taking that 2% early payment discount, you effectively earned a 45.67% annual return on the $9,800 for those 20 days it was paid earlier! When looked at over a full year’s time, that 2% discount equates to an astronomical 45.67% annual yield.
This is why taking advantage of early payment discount terms can be so valuable for a business’s profitability and cash management. Of course, there is an opportunity cost of tying up that money 20 days sooner. But in most cases, the extremely high annualized return far outweighs that cost or lost opportunity.
Some other examples at common discount rates:
1/10 net 30 terms = 18.25% annualized return
2/15 net 60 terms = 44.63% annualized return
3/10 net 60 terms = 109.65% annualized return
As you can see, the higher the discount percentage and the longer the net term, the higher the annualized yield from taking that early payment discount. Rates over 100% are absolutely possible in the right scenarios.
Some Important Warnings to Consider
Here are some important warnings to consider in this case:
The annualized returns shown assume you could infinitely reinvest that same discount amount over and over for a whole year. In practice, each discount applies to just one invoice payment, so the lifetime return will be less than the annualized rate. However, businesses with consistent cash flows can compound the effect over many invoices.
You must have the cash available to pay that invoice early without creating a cash flow crunch in other areas of your business. The return is meaningless if taking the discount forces you into an overdraft or having to borrow at a higher rate to cover other obligations.
Make sure you actually pay within the discount window, as most suppliers enforce it strictly and won’t allow the discount beyond those initial few days.
Exceptions may apply if the invoice has errors or there are other disputes. Don’t deduct the discount prematurely until those are resolved.
Also Read: Early Payment Discounts: Should You Use Them in Your Business?
Conclusion
Despite those considerations, the potential ROI from early payment discounts is undeniable for businesses that can qualify for and capitalize on them. Make sure you or your accounting team understand the terms every time they appear on supplier invoices. Even seemingly small discount percentages equate to massive annual returns. It’s an opportunity that shouldn’t be overlooked in your overall cash management strategy.
Also Read: Early Payment Discounts: Realizing Value in Accounts Payable