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