Q: If a supplier offers a discount for early payment, should I always take advantage of it even though I must borrow from my bank line of credit to do so?

A: One way to think about this would be to take an example from your personal life.

If you are shopping and see an item on sale that is enticing and you need to use your credit card to buy the product, would you do it? Or would you buy the item later with cash instead, even though the item is no longer on sale, having to pay full price?

Perhaps you would do calculations to determine whether you are saving money and taking in account the interest rate on your credit card.

Similar to the consumer example, one needs to compare the cost of the bank loan vs. the cost of trade credit.

For instance, suppose the supplier offers terms of 1/10 net 90. This means that the supplier will give you a 1 percent discount, if you pay within 10 days.

If you do not pay within 10 days, you can just pay the full invoice amount in 90 days. In this case, think of forgoing the discount as the same as paying interest to borrow money for 80 days.

Basically, the vendor is saying, “Ten days is the same as cash.” If you do not pay within 10 days, then you can wait another 80 days (a total of 90 days from the first invoice).

Therefore, use the following formula to get an approximation of the annual interest rate:

Approximate interest rate = (Discount/100 - Discount) x (365/(Net time - Discount period)) x 100

For instance, 1/10 net 90 terms is the approximate interest rate equivalent of:

(1/99) x (365/(90 - 10)) x 100 = 4.6 percent

In other words, giving up the 1 percent discount and paying every order from this supplier on day 90 will, over the course of a year, add 4.6 percent to your total purchasing expenses.

Accordingly, if your line of credit is cheaper than 4.6 percent, you should borrow and pay the bill within 10 days.

If your bank charges you more than 4.6 percent, then just pay on day 90.

 

David Vang is a finance professor at the University of St. Thomas Opus College of Business.