If ESCO pays the vendor’s $10,000 invoice having terms of 2/10, net 30 within 10 days instead of in 30 days, ESCO will save paying $200 ($10,000 X 2%). In other words, ESCO will save $200 for paying 20 days earlier than the due date.
To annualize the percentage earned/saved, we will convert both the $200 and the 20 days to annual amounts. This is done by multiplying both the $200 and the 20 days by 18:
- Amount saved on an annual basis: $200 X 18 = $3,600
- Converting 20 days to a year: 20 days X 18 = 360 days
Saving $3,600 per year on an investment of $9,800 or $10,000 = approximately 36% on an annual basis.
The annual percentage assumes there will always be invoices offering the 2/10 early payment discounts throughout the year.
If a company must borrow money for 20 days at the loan interest rate at 12% per year in order to pay the $10,000 invoice in the discount period, the net savings will be $135.56:
- Loan interest expense from borrowing: $64.44 ($9,800 X 12% per year X 20 days/365 days)
- Early payment discount: $200.00 ($10,000 X 2%)
- Savings after subtracting the loan interest $135.56 ($200.00 minus $64.44)
Note that the $200 early payment discount is approximately 3 times the 12% interest rate on the loan. This also indicates that the annual interest rate earned by paying within the discount period is approximately 36%.