Or: Why You Might Be Paying 36% Interest to Get Your Own Money Faster
“Cash flow is king,” they say.
But what if I told you that one of the most common ways businesses try to improve it, by offering early payment discounts like 2/10; Net-30, is basically giving out high-interest loans… to your customers?
And I’m not being dramatic. I’m talking 36.7% annualized interest (44% if you compound it!). That’s loan-shark territory. All for the pleasure of getting paid 20 days sooner.
Let’s break this down.
What is 2/10; Net-30?
It’s shorthand on an invoice that means:
“You get a 2% discount if you pay me within 10 days. Otherwise, I expect full payment in 30 days.”
Sounds innocent. Even helpful. You’re giving your customer a little carrot to pay faster. Maybe you’ve even been taught this is good business practice. I used to teach finance at Humber College and my (accountant) colleagues taught this as if it was a routine, beneficial practice.
Spoiler alert: It’s not. At least not for most small businesses.
Do the Math, Then Pick Your Jaw Off the Floor
Let’s say you invoice a client for $10,000. Normally, they pay in 30 days. You offer them a 2% discount if they pay in 10 days. That saves them $200 and costs you the same.
So you get $9,800 instead of $10,000. And you get it 20 days earlier. Not bad, right?
Wrong!
The annualized cost of that $200 “cash advance” is a whopping 36.7%.
Thirty. Six. Point. Seven. Percent. (44% if you compound it)
You could get a short-term business loan or a line of credit for a third of that cost. Hell, your personal credit card is only 1/2 as expensive.
How is it so expensive? Here’s the math…
The customer is paying 20 days early. You need to process that in your brain as a 20-day loan. They’re technically not obligated to pay you the money for another 20 days, so they are “loaning” you the money. The cost of that loan is 2% for 20 days, or 0.1%/day. Multiply that by 365 and you get a jaw-dropping 36.5% annual cost.
Why are you borrowing money at rates twice what a credit card charges a high-school student?
What Should You Do Instead of Prepayment Discounts
If you’re using early payment discounts to smooth out your cash flow, there are better ways:
Invoice factoring: Sell your receivables to a third party. Yes, you’ll pay a fee, but it’ll likely be way less than 36%. Bonus: they can take on the collection risk.
Tighter credit policy: Don’t wait 60 days for chronic late payers. Set expectations up front and enforce them. Become a pain in their behinds! Automated follow-ups the day after sending the invoice, and then 10 and 3 days before payment is due, can do wonders.
Use Deposits and Milestone Payments: For project-based work, bill upfront or in chunks. No need to offer a discount when you’re already holding a portion of the cash.
When Might a Discount Make Sense?
To be fair, sometimes it’s the best of bad options. It’s ok if every once in a while, you have to!
- You’re in a liquidity crunch, and fast cash matters more than margins. Sometimes time is tight and options are limited. As long as this is something you do only here and there, there’s little harm in it.
- If you’ve got massive margins and these terms accelerate a lot of volume, the math might work (the key here is to DO the math!).
- The customer always pays early, and you’ve priced it in.
- You’re trying to hit a liquidity target or sweeten a key relationship.
- You’ve got fat margins and this accelerates big volumes that bring scale advantages.
So there are definitely times it’s ok, but it should be intentional, not automatic.
Final Word: Be a Banker, but On Purpose!
You wouldn’t borrow money at 36% interest to fund your business. But, would you invest it at that rate? Would you lend your supplier money at that rate?
In other words, when it comes to these discounts…
“Would I take this deal if the roles were reversed?”
If you’re the one receiving a 2/10, Net-30 offer, you should practically sprint to your checkbook. Why? Because taking that 2% discount for paying 20 days early is the equivalent of earning a 36.7% annualized return. If you have enough payables and are cash rich, you can earn a nice return just on the entirely risk-free activity of paying your bills early.
Do you earn a 36.7% return on the other assets that are in use at your firm? Does your retirement account earn that. Remember, it’s a RISK-FREE investment! You’re getting paid to do something that you were going to do anyway, pay your bill.
It’s better than almost anything legal.
So yes, as a seller, you may want to think twice. But as a buyer? Take the deal. Every time.
If you’re contemplating a different discount structure and want to know the cost, download my easy-to-use Excel Prepayment Discount Cost Calculator to plug in your own terms and see what you’re really giving away..
Looking for Additional Resources?
Better Cash Flow Management Tools
FundThrough (Invoice Factoring for Small Business)
https://www.fundthrough.com/
Float (Cash Flow Forecasting Software)
https://www.floatapp.com/
Small Business Financial Resources
BDC’s guide to managing cash flow in Canada:
bdc.ca/guide
Canadian government advice on financing growth:
ised.canada.ca/research
Want to better understand why you feel poor despite growing sales? Check out this post about cash flow issues.
