Sometime patience is key and other times it's your risk aversion
What is 2/10 Net 30?
A common technique is present among businesses, particularly small ones, to collect money that's owed to them (i.e. in their accounts receivable). This technique is called the 2/10 Net 30 discount. You may also hear variations of it but it is essentially a 2% incentive to pay money back with 10 days, rather than the 30. It is so common among business practices that you can even find it in most accounting software.
For example with easy math, pretend your business (Business A) lent $12,000 at 0% interest to another business (Business B) and expected to receive $1,000 a month. You may offer the 2/10 Net 30 discount to Business B so that if they pay you within 10 days of the month, they only need to pay $980.
There are two key benefits that come from using this discount. First, is risk. If you lent the money out to a risky borrower or if the business environment has brought a lot of uncertainty, offering a discount might put your receivables in a higher priority for the business who is borrowing and simply make it easier for them to pay. Essentially, it increases your margin of safety. The thinking is that a 2% discount is better than no money back.
Secondly, is the concept of the time value of money. The sooner you get the money back the faster you can deploy it into the business again right? Well... this is where we disagree.
The Cost, Opportunity Cost that is
Sometimes patience is key. If you get 98% of your money in 10 days that means you have to find a way to get 2.04% within the remaining days of the month.
Fun Fact: This means February is the worst time for the 2/10 Net 30 discount!
Assuming a 31-day month (using the best case scenario in favor of the 2/10 Net 30 discount) that means you would need to find an opportunity with an annualized return of 42% which is no easy task. Below is the formatted annualized rate of return formula in relation to the opportunity cost that it must beat in order for it to be mathematically efficient.
Although we can agree with the first benefit, that it might help with risky lenders or lenders in risky situations, mathematically the 2/10 Net 30 discount most likely is not beneficial. One paradigm shift in thinking we have to use is when accounting for the risk of the lenders we need to ask ourselves what value is this risk worth? It's hard to put a value on the risk of the lender but it is much easier to value the opportunity cost and ask ourselves if the discount delivers more value than the opportunity cost. The relationship comparison helps make the decision making much more rational.
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