Managing Accounts Payable

Now let’s shift from accounts receivable to accounts payable. Accounts payable answers the question, “Are we paying down our debts as slowly as possible?” We want to pay down our debts as slowly as possible to hold onto that cash to use for other purposes.

We talked about discounts from the perspective of the seller. Now let’s talk about discounts from the perspective of the buyer. As the buyer, we don’t want to pay early and get the discount until we first analyze whether it’s worth it or not for us. There’s a formula here that we can use:

Annual Rate = Periods Per Year With Discount X Effective Discount Rate

The underlying idea of this formula is, “What is the annual percentage rate if we don’t pay the discount and hold onto our cash for longer?” Why the annual percentage rate? Because if we pay our AP, let’s say 20 days early, and we receive a 2% discount, it’s going to be much greater than a 2% discount on an annual basis.

Let’s say we have the following terms: 2/10, Net 30. We can pay within 30 days and not get a discount, or we can pay within 10 days and get a 2% discount. If we pay within 10 days, we get a 2% discount. If we don’t take the discount, then we have 20 more days to hold onto our cash before we pay it. That means, in other words, that we’re incentivized with 2% for giving up our cash 20 days early.

How do we annualize this 2% discount? We get a discount for paying 20 days early and how many 20-day periods are there in a year? Assuming a 360-day year, there are 18 periods of 20 days in a year. Now we have to find out the effective rate of a 2% discount. If we were going to pay $100, we get a 2% discount.

Now we’re paying $98. For the effective rate, instead of dividing 2% over 100%, we divide 2% over 98%. Our effective rate is 2.04% (2%/98%). To reiterate this concept, we’re getting a 2% discount and paying $98. We divide the 2% discount by the $98, which is a 2.04% effective rate. You’ll notice that the effective rate is going to be higher than the stated rate of 2%.

This part of the calculation causes a small difference in the final answer, so if it’s easier for you, modify the formula to the following:

Simplified Annual Rate = Periods Per Year X Discount Rate

Now that we have the effective rate, the rest of the calculation is straightforward. We multiply the effective rate of 2.04% by the number of 20-day periods in the year 18. That means that our discount annualized rate is 36.72% (20 X 2.04%). What does this mean? It means that if we don’t take the discount of 2%, then we’re giving up an annual return of 36.72%.

If we don’t pay early, then we hold onto our cash. But if we can’t find an alternate use of our cash that generates more than a 36.72% return, then we should pay early and get the discount.