Introduction to Corporate Finance

19: Cash, Payables and Liquidity Management

19-3b CASH DISCOUNTS

When suppliers offer cash discounts to encourage customers to pay before the end of the credit period, it

may not be in the company’s best financial interest to pay on the last day of the credit period. Accounts

payable with cash discounts have stated credit terms, such as 2/10 net 30, which means the purchaser

can take a 2% discount from the invoice amount if the payment is made within 10 days of the beginning

of the credit period; otherwise, it must pay the full amount within 30 days of the beginning of the credit

period. The credit period begins at a specific date set by the supplier, typically either the end of the

month in which the purchase is made (noted as ‘EOM’) or on the date of the invoice. Taking the discount

is at the discretion of the purchaser.

When a company is extended credit terms that include a cash discount, it has two options: (1) pay the

full invoice amount at the end of the credit period; or (2) pay the invoice amount less the cash discount

at the end of the cash discount period. In either case, the company purchases the same goods. Thus, the

difference between the payment amount without and with the cash discount is, in effect, the interest

payment made by the company to its supplier.

A company in need of short-term funds must therefore compare the interest rate charged by its

supplier to the best rate charged by lenders of short-term financing (typically banks) and then choose the

lowest-cost option. This comparison is important because, by taking a cash discount, the company will

shorten its average payment period and thus increase the amount of resources it has invested in operating

assets, which will require additional negotiated short-term financing.

To calculate the relevant cost, we assume that the company will always render payment on the final

day of the specified payment period – credit period or cash discount period. Equation 19.2 presents the

formula for calculating the interest rate, rdiscount’ associated with not taking the cash discount and paying at

the end of the credit period when cash discount terms are offered:

Eq. 19.2
r

d

1 dCPDP

365

discount

()()

=

−

×

−

where

d = % discount (in decimal form)

CP = Credit period

DP = Cash discount period

example

Assume that a supplier to Leederville Industries
has changed its terms from net 30 to 2/10 net 30.
Leederville has an overdraft with a bank, and the
current interest rate on that overdraft is 6.75% per
year. Should Leederville take the cash discount or
continue to use 30 days of credit from its supplier?
The interest rate from the supplier is calculated using
Equation 19.2:

r

0.02

10 .02

365

30 10

discount= 0.372 37.2%peryear

−

×

−

==

Thus, the annualised rate charged by the supplier

to those customers not taking the cash discount is

37.2%, whereas the bank charges 6.75%. Leederville

should take the cash discount and obtain any needed

short-term financing by drawing on its bank overdraft.

What is the financial trade-off

involved when a company

evaluates whether or not to

take an offered cash discount?

thinking cap

question