Calculating cash discount: formulas and meaning
Discount amount, payment amount and the effective annual interest rate explained simply
Cash discount (also known as an early-payment or prompt-payment discount) is a price reduction that suppliers grant when an invoice is settled especially quickly — within the so-called discount period. The discount amount is calculated as: discount amount = invoice amount × discount rate ÷ 100. The payment amount after deducting the discount is the invoice amount minus the discount amount.
More interesting than the discount amount itself is the effective annual interest rate that a business effectively forgoes when it lets the discount period lapse and instead pays only at the full payment term. During that period, the business is essentially using a short-term credit from the supplier. The commercial formula for this is: effective rate = [discount rate ÷ (100 − discount rate)] × [360 ÷ (payment term − discount period)] × 100. The 360 stands for the commercial year of 12 × 30 days.
At typical conditions (e.g. 2% discount, a 10-day discount period, and a 30-day payment term), the resulting interest rate is often above 35% p.a. — significantly higher than the interest on an overdraft facility. This makes taking the cash discount economically worthwhile in most cases, even if it means taking out a short-term loan to do so.