Building a consistent earnings stream and an adequate amount of cash reserves in order to mitigate the impact of any unanticipated financial risk should be the goal of any small business owner. However, just maximizing cash reserves can be costly and create other types of business risk. One cash management tool that most vendors give small business owners is the ability to take advantage of prompt-pay discounts. Paying credit invoices can reduce the overall cost of your payables, but it can also reduce the amount of working capital you have as a cushion against unexpected financial troubles. As part of the overall forecasting and income management function, owners should determine how much of the prompt-pay discount, if any, is appropriate for their particular business.
Vendors that provide your business credit by invoice terms such as “Net 30” (a no cost grace period of thirty days to pay), is effectively giving your business a short-term interest free loan. In order to motivate prompt payment and increase the velocity of their receivables turnover, vendors will often give prompt pay discounts. For example, a billing term such as “2/10 Net 30” still provides the 30 day grace period but in addition provides a 2% discount if the bill is paid within 10 days. Now, on the surface you may think that it is in your firm’s best interest to take the 2% discount, but this may not be the case. Determining whether you should take the discount should be based on a myriad of factors. It may be a function of the discount, the time period, your current cash balances, your firm’s Accounts Receivable turnover, or your expectations for the upcoming period’s sales. It is also not safe to say that taking the discount will always be or not be a good decision. In some situations it may be a no brainer, and in other situations it may make the difference between booking a profit or a loss for the period.
Determining the answers to questions like whether your firm can take advantage of prompt-pay discounts is the reason why owners forecast their cash flows on a regular basis. Running scenarios without and including the discounts will give you insight on whether it makes more sense to retain the cash or to take the cost savings.
In addition to doing scenario analysis, there are more formal ways to approach the prompt payment question. With the help of the external accounting help or a finance manager, most owners will determine their cost of capital and the return what they need to receive in order to invest their capital back into the business. If that investment hurdle rate is known, then it can be calculated using the cost savings from the prompt-pay discount to determine if the return that can be obtained is worth paying the money early. The formula accounting professionals use to help determine the effective annual return for taking a prompt pay discount is:
(Amount of discount/discounted price) multiplied by (number of days in the year/number of days paid early)
Using this formula, a small business owner can calculate the payback for paying their invoices early. If the return is high enough and it doesn’t have a negative impact on the business, then you should consider paying invoices early. For example, if a $10,000 invoice is billed “2/10 Net 30”, then the firm would save an additional $2,000 for paying the invoice within 10 days. Using this information the return calculation would be the following, which equals 36.7%.
(2,000/9,800) multiplied by (360*/20) equals 0.367, or 36.7 percent
In this case, if 36.7% is an acceptable return and is at least as great as that that is received by investing in the business, and making the payment early will not add additional stress on the business that it cannot handle, then the advanced payment should be made.
The only way to ensure that the business can handle the prepayment is to forecast revenues and expenses with the prepayment included to make sure that there isn’t a risk that the business will fall below its minimum income and cash requirements. The first thing you have to find out is whether your cash flow will allow you to pay early enough to take the discount. In addition to the forecast, owners should take into consideration the firm’s cash cycle, the timing of the monthly flows of cash into and out of your business. Before making these types of decisions, owners should know what the minimum amount of working capital is necessary to cover upcoming expenses. If that requirement cannot be met then the firm may want to suspend taking the discounts until minimum cash reserves are met.
Although an aggressive policy, owners may take advantage of credit lines or loans to make the prepayments. If the return for making the payments are significantly greater than the cost of credit (interest rate on the loan), and repaying the loan or credit line is not an issue, then borrowing may be an appropriate way to make a little extra income through cost savings. For example if $1 million in invoices are billed in one year under the same “2/10 Net 30” terms than the company could save an additional $20,000. However, in order to prepay the extra 20 days of cash flow the company would have to borrow approximately $55,000. [($1 million/ 365 days) x 20 days early = $54795]. If the loan or credit line carries a 7% interest rate then the funds if borrowed for the entire year would cost # approximately $4,000 [($54,795 x 7%) = $3,836]. If the funds are repaid within that year period the company would make an additional $16,000 from borrowing and taking the prompt-payment discounts. Borrowing money still requires, and may make it more important, to forecast cash flows to ensure that future income will provide enough cash flow to pay back the loan or credit line within an appropriate amount of time.
So should you take advantage of prompt-pay discounts? The answer is yes, if it is appropriate for your business. In many cases the return for taking advantage of the discounts will be more than the return from investing money in your business. Since the returns are usually significant, this type of decision making underscores the importance of forecasting and cash flow management. Being diligent and disciplined in managing your business; cash flow is what will keep the business out of the financial ditches and help you maximize its value. Keeping your business stabile and consistent is rewarded in many other ways, such as supporting its reputation in the marketplace as a low risk place to conduct business.