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Occasionally a supplier will provide you with an “incentive” for paying an invoice before its due date. These are often referred to as “terms discounts.” A common terms discount is “2% 10 Days Net 30 Days.” This means that while the vendor expects to be paid within 30 days of the invoice date, he or she will allow the customer an additional 2% discount if the invoice is paid within 10 days of the invoice date. This month a reader sent an email asking why we almost always recommend taking advantage of these discounts.

For example, the vendor is offering a 2% discount off the cost of the material on an invoice if you pay for the material 20 days earlier than you normally would – that is, you pay for it in 10 days rather than 30 days. If you earn a 2% return every 20 days, you will earn more than a 36% return on your investment every year. Where did I come up with this fantastic return?

There are 365 days in a year, or about eighteen 20-day periods (18 * 20 days = 360 days). If I can earn 2% 18 times during the year, the result is about a 36% annual return (2% * 18 = 36%)! Even if I have to borrow money at a 6% annual interest rate, it makes sense to take advantage of this terms discount of “2% 10 Days Net 30 Days.” Even a terms discount of “1% 10 Days Net 30 Days” provides you with about an 18% annual return (1% * 18 = 18%). Even borrowing money at 6% seems worth it to get an annual return of 18% or 36%.

Keep in mind that another vendor offer of “extended terms” does not provide nearly the same return on your investment. When a vendor offers extended terms, he or she is giving you more time to pay an invoice. Common extended terms include paying an invoice in “60 Days Rather Than 30 Days” or “90 Days Rather Than 30 Days.” What this means is that the vendor is giving you free use of money for either 30 days in the case of “60 Days Rather Than 30 Days” (60 Days – Normal Pay Period of 30 Days = 30 Days) or 60 days in the case of “90 Days Rather Than 30 Days” (90 Days – Normal Pay Period of 30 Days = 60 Days). Your savings are the cost of money for either the 30-day or 60-day period. If you could borrow money at 6% per year or 0.5% per month:

• Extended terms of “60 Days Rather Than 30 Days” gives you an additional one-half percent discount on your order (1 month * 0.5% per month = 0.5%).
• Extended terms of “90 Days Rather Than 30 Days” results in an additional 1% discount on your order (2 months * 0.5% per month = 1%).

I strongly believe that you must stay disciplined to check the math on these offers. It has been my experience that it is almost always a good idea to take advantage of terms discounts. However, even though it may sound advantageous to take advantage of extended terms, they usually don’t provide a discount worth pursuing.