Companies often buy or sell goods and services on credit, allowing them to delay cash payments and match their cash inflows and outflows. Some companies offer cash discounts to customers who pay bills early. For example, if a vendor specifies “2/10, net 30” on a sales invoice, the customer gets a 2 percent discount if he pays the bill within 10 days, which is the discount period; otherwise, the balance is due in 30 days, which is the credit period. The effective annual rate is the annualized implied cost of forgoing the discount. It is a factor of the discount rate and the difference between the credit period and the discount period.
Get the credit terms, which are usually on the invoice. For example, if the discount term is “1/10, net 45,” the customer gets a 1 percent discount if he pays within the discount period of 10 days; otherwise, the balance is due within the credit period of 45 days.
Compute the implied cost for not paying within the discount period and forgoing the cash discount. Divide the cash discount percentage by (100 percent minus the cash discount percentage) and express the result as a percentage. Continuing with the example, the cost, expressed as a percentage, is equal to 100 multiplied by (1 percent divided by (100 percent minus 1 percent)), or 1.01 percent.
Calculate the effective annual rate. Divide 365 by the difference between the credit and the discount periods, then multiply that result by the implied cost. To conclude the example, the effective annual rate is equal to 1.01 percent multiplied by (365 divided by (45 minus 10)), or approximately 10.5 percent.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.