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At the outset, you need to understand each input and output variable of this calculator.
Invoice Amount ($): The total bill you owe to the supplier before any discounts. This is the base amount on which the discount will be calculated.
IMPORTANT: Note, exclude taxes like sales tax, VAT, or GST from this invoice amount since the discount never applies to the tax amount. These taxes need to be remitted to the government; therefore, the question of a discount on the tax part doesn’t arise. For example, if the total invoice amount is $12000 which includes a sales tax/VAT/GST of $2000, enter 10000 as the invoice amount in the calculator above.
Discount (%): The percentage discount offered by your supplier if you pay early. For example, you normally pay the supplier within 30 days, and if your supplier offers a 2% discount on the invoice amount if you pay within 10 days, enter 2 as discount% in the calculator above.
Discount Days: The number of days from the invoice date within which you must pay to qualify for the discount. For example, you normally pay the supplier within 30 days, and if your supplier offers a 2% discount on the invoice amount if you pay within 10 days, enter 10 as discount days in the calculator above.
Standard Payment Days: The usual number of days you’ve to pay the invoice in full if you don’t take the early payment discount offer. For example, you normally pay the supplier within 30 days, and if your supplier offers a 2% discount on the invoice amount if you pay within 10 days, enter 30 as the standard payment days in the calculator above.
Cost of Capital (%): It’s the rate you pay if you borrow money, or the minimum rate of return you expect if you use own cash. What is the minimum rate here? It’s the rate you can earn by investing your cash elsewhere.
For example, if your loan interest is 9.50%, that’s your cost of capital.
For example, if you’ve invested your own cash into your business (have taken no loans), and you can earn 12% if you invest this cash elsewhere, this 12% is your cost of capital and the minimum return you expect by deploying your own cash into your business.
Now, what if your capital comprises both loans and your own cash? Well, in this case, you need to calculate the WACC (weighted average cost of capital) which is nothing but the weighted average of the cost of capital derived from both sources: loan and cash.
Invoice Discount: The actual dollar amount saved by paying early. For example, a 2% discount on an invoice amount of $10000 translates into an invoice discount of $200.
Effective Discount Rate: The true early payment discount rate calculated on the invoice amount after the discount.
For example, if a supplier offers a discount of 2% on a $10000 invoice for early payment, the effective or true discount rate will be over 2%. Why? Because you’re not investing or paying the full invoice amount. The $200 discount is earned on $9800, not $10000. So, the effective discount rate is ($200/$9800) x 100 = 2.04%
Annualized Effective Discount Rate: The effective discount rate, scaled to a yearly basis.
Step 1: Apply suppliers discount to invoice amount to calculate invoice discount
Invoice discount = Invoice amount x discount%
Invoice discount = $10000 x 2% = $200
Step 2: Determine the invoice amount after the discount
Invoice amount after discount = Invoice amount - invoice discount
Invoice amount after discount = $10000 - $200 = $9800
Step 3: Calculate the effective discount rate
Effective discount rate = (Invoice discount / Invoice amount after discount) x 100
Effective discount rate = ($200 / $9800) x 100 = 2.04%
Step 4: Find the time window difference
Time difference (in days) = Standard payment days - discount days
Time difference (in days) = 30 - 10 = 20 days
Step 5: Annualize the effective discount rate
Annualized effective discount rate = Effective discount rate x (365 / time difference (days))
Annualized effective discount rate = 2.04 x (365 / 20 days) = 37.24%
Step 6: Compare the annualized effective discount rate with the cost of capital
If the annualized effective discount rate > cost of capital, take the early payment offer.
If the annualized effective discount rate <= cost of capital, don’t take the early payment offer.
Look, a discount is a kind of return for your business. You pay early and get a financial return (discount). If the early payment results in a return that exceeds the cost of capital (minimum return you expect), that means the early payment offer makes financial sense.