What Are Trade Credit Terms?

Trade credit terms (also known as payment terms) dictate how and when a buyer must pay a supplier for goods or services. They are often displayed in a shorthand format like "2/10 Net 30".

• 2: The percentage discount offered (2%).
• 10: The number of days the buyer has to pay to receive the discount (10 days).
• Net 30: If the discount is not taken, the full invoice amount is due in 30 days.

The Cost of Missing the Discount

Many businesses mistakenly believe that missing a 2% discount is a minor cost. In reality, the cost of giving up that discount is usually enormous. If terms are 2/10 Net 30, and you pay on day 30 instead of day 10, you are effectively borrowing the invoice amount from your supplier for exactly 20 days (30 - 10 = 20).

You pay a 2% "interest" charge (by losing the discount) for a 20-day loan. If you scale that up to a full year (365 days / 20 days = 18.25 periods), that 2% charge compounds to an Effective Annual Rate (EAR) of over 44%!

When to Take the Discount

To decide whether to take the discount, you must compare the Effective Annual Rate (EAR) of missing the discount to your company's actual cost of borrowing (e.g., your Line of Credit rate from a bank).

• If the EAR of missing the discount > Bank Rate: Borrow money from the bank to pay the supplier on Day 10. You will save money.
• If the EAR of missing the discount < Bank Rate: Skip the discount, keep your cash, and pay the supplier on Day 30.

Because the EAR of standard terms like 1/10 Net 30 (18% EAR) or 2/10 Net 30 (44% EAR) is almost always higher than standard commercial lending rates, it is almost always financially optimal to take the discount.