If a supplier offers a discount for early payment, does it pay to pay even if you have to borrow?
"Pay within 10 days and get a 2% discount" looks like a small number. But on an annual basis it can turn out to be more expensive than many bank loans. We calculate it using a sewing factory as an example.
The "Oydin Tekstil" sewing factory bought fabric worth 200 mln soum from the "Marg'ilon Ipak" company. The payment terms say: if paid within 10 days, a 2% discount; otherwise the full amount is paid within 30 days.
Finance director Sardor hesitated. There is no spare money in the account right now. Is it worth taking a short-term bank loan for the discount?
Giving up the discount is really borrowing
The factory could pay 196 mln soum on day 10. If it pays on day 30, it pays 200 mln. That is, for keeping 196 mln soum for another 20 days, it pays the supplier 4 mln soum of "interest".
The annual cost of this "interest" is easy to calculate:
Annual cost = discount ÷ (100 − discount) × 365 ÷ (full payment term − discount term)
For "Oydin Tekstil": - cost for 20 days: 2 ÷ 98 = 2.04%; - annual cost: 2.04% × 365 ÷ 20 = 37.24%.
This is calculated with simple interest. If you calculate with compound interest, the result is even higher: about 44.6%.
How much do different terms cost?
| Terms | Discount | Discount term | Full payment term | Annual cost of giving up the discount |
|---|---|---|---|---|
| 1/10, 30 | 1% | 10 days | 30 days | 18.43% |
| 2/10, 30 | 2% | 10 days | 30 days | 37.24% |
| 2/10, 60 | 2% | 10 days | 60 days | 14.90% |
| 3/15, 45 | 3% | 15 days | 45 days | 37.63% |
Note: the same 2% discount costs 37.24% on 30-day terms, but only 14.90% on 60-day terms. What decides is not the discount percentage but the number of extra days.
Comparing with a bank loan
Suppose the bank lends for 20 days at an annual rate of 24% (hypothetical).
| Indicator | Amount, soum |
|---|---|
| Discount (benefit gained) | 4 000 000 |
| Loan interest: 196 000 000 × 24% × 20 ÷ 365 | 2 577 534 |
| Net benefit | 1 422 466 |
Taking the loan and paying on day 10 gives the factory a benefit of 1.4 mln soum. If the terms had been 2/10, 60 (14.90%), paying with a 24% loan would have been a loss.
The same logic works even if you have spare money. Compare the income from keeping the money on deposit with the annual cost of the discount.
What should you watch for in the accounts?
Paragraph 16 of NAS No. 4 distinguishes two situations: - a discount used at the date the inventory is received reduces the value of the inventory purchased; - a discount received after the inventory is received, as a result of fulfilling the contract terms, is taken to the organization's financial results and does not reduce the value of the inventory.
In the case of "Oydin Tekstil", the fabric is received first, and the discount arises later, after payment within 10 days. So this is the second situation: the cost of the fabric stays at 200 mln soum, and the 4 mln soum affects financial results. The discount must be documented with a supporting document.
Practical tips
- Convert each supplier's terms into an annual percentage using the formula above and write it in a table.
- Put the discount deadline into the payment calendar. If paid on day 11, the discount is lost.
- Add not only interest but also bank fees to the cost of the loan.
- Before taking a loan for a discount, check the cash flow plan: will money from customers definitely come in by day 30?
Test yourself
5 questions on this topic: pick an option or reveal the answer.
A tenant promised to pay the "Bog'bon" farm 1 210 000 soum at the end of year 1 and at the end of year 2. The discount rate is 10% per year. What is the total present value of these two payments?
The annual net profit of a joint-stock company was 90 mln soum, of which 36 mln soum was allocated to dividends (hypothetical example). What is the dividend payout ratio (dividends / net profit × 100%) and what does it mean?
Retained earnings of the reporting period were allocated to paying dividends to the founders. What journal entry is made?
The par value of a "Marg'ilon atlas" JSC share is 10 000 soum, and its current exchange price is 16 000 soum. The company paid an annual dividend of 1 200 soum per share (hypothetical example). What is the dividend yield (annual dividend per share / current market price of the share)?
"Sirdaryo don" LLC owns 2 500 shares of another joint-stock company. The company announced a decision to pay a dividend of 800 soum per share; the money has not yet been received (hypothetical example). What is the dividend amount and the journal entry under NAS No. 21?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- NAS No. 4 "Inventories", paragraph 16 · a discount used at the date of receipt reduces the value of inventory; a discount received after receipt as a result of fulfilling contract terms is taken to financial results
- Example, interest rates and calculations · compiled by the author, hypothetical