What do the numbers mean

For most companies, taking advantage of these discounts makes sense as long as the annual interest rate calculated using this formula is higher than the one they must pay if they borrow money to pay the bill early. This becomes a big issue for companies because unless their inventory turns over very rapidly, 10 days probably isn't enough time to sell all the inventory purchased before they must pay the bill early. Their cash wouldn't come from sales but, more likely, from borrowing.

If cash flow is tight, a company has to borrow funds using its credit line to take advantage of the discount. For example, if the company buys $100,000 in goods to be sold at terms of 2/10 net 30, it can save $2,000 by paying within 10 days. If the company hasn't sold all the goods, it has to borrow the $100,000 for 20 days, which wouldn't be necessary if it didn't try to take advantage of the discount. I assume that the annual interest on the company's credit line is 9 percent. Does it make sense to borrow the money?

The company would need to pay the additional interest on the amount borrowed only for 20 additional days (because that's the number of days the company must pay the bill early). Calculating the annual interest of 9 percent of $100,000 equals $9,000, or $25 per day. Borrowing that money would cost an additional $500 ($25 times 20 days). So even though the company must borrow the money to pay the bill early, the $2,000 discount would still save it $1,500 more than the $500 interest cost involved in borrowing the money.

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