“Watch the pennies and the dollars will take care of themselves.” – Benjamin Franklin

I was talking to a couple of great entrepreneurs the other day about a topic that plagues most businesses – cash flow. We were talking about having the ability to take advantage of vendor discounts. I knew the typical 2 percent/10-day discount was a great deal but couldn’t remember how the math worked.

I went back to my office and looked it up. I knew those types of discounts were a great deal for businesses that have the cash to take advantage of them, but I was amazed at how great of a deal they are.

Whether you should use discounts is a cost of capital discussion. The vendors who offer these discounts are choosing to use your money as a form of capital. They have agreed to pay you the cost of the discount in exchange for using your capital to fund their business.

Since most businesses fail because they are under-capitalized – not because the concept wouldn’t have worked – the cost of capital is a relevant discussion for everyone in business.

Here’s the scenario. You run a growing business and cash is tight. You have a vendor invoice in front of you offering you a 2 percent discount if you will pay the invoice in the next 10 days instead of the typical 30 days. This is the typical 2/10 discount you’ve probably seen before.

What is the “cost” of not taking advantage of the vendor discount? To keep the math simple, let’s assume you owe the vendor $1,000 and your payment is generally due in 30 days. To incentivize early payment, the vendor is offering a 2 percent discount if you pay within 10 days rather than 30.

What interest rate is the vendor paying you to finance their business? Here is the math:

Interest rate for 20 days = Interest / Principal

Principal = $980 (amount received from customer)

Interest = Discount Offered = $20 ($1,000 x 2 percent)

Term = Normal Terms – Discount Terms = 20 days (30-10)

Interest rate for 20 days = $20 / $980 = 2.04 percent

This is the rate the vendor is paying to use your funds for 20 days. We’ll need to convert this to an annual rate so we can compare it to other financing options. To annualize the interest rate, divide the rate by the days to convert to a daily rate.

2.04 percent/20 = .102 percent

Then multiply the daily rate times 365 to get the annualized rate.

.102 percent x 365 = 37.23 percent

Wow. 37.23 percent is a very high cost of capital. But wait. 37.23 percent is the effective interest rate if you take the discount one time. If the vendor offers and you take the discount every month the cost to the vendor and benefit to the buyer compounds. The math gets a little tricky, but here it is.

EAR = (1 + i / m) m – 1

EAR = Effective Annual Rate

i = Annual Nominal Rate of Interest. Use 37.23 percent from the above calculation.

m = Number of compounding periods in a year. We can take this offer 12 times per year, so we’ll use 12.

EAR = (1 + 37.23 percent/12) 12 – 1 = (1 + 37.23 percent/12) 12 – 1 = 44.28 percent

Are you surprised by how much a discount is worth to buyers or how much it costs vendors? By the way, the effective annual rate for 1 percent/10 terms is 20.1 percent.

If you are a buyer, what kind of capital could you use to take advantage of great discounts when they are offered?

If you are a seller, how could you get cheaper financing than offering discounts?