Valuing the Speed of Cash Flow

For many businesses – even very large ones – the question of how to value the speed of cash flow can be a confusing one.  Many of our clients frankly don’t have the time to consider what seems to be a vague finance concept.  They instead rely on “Rules of Thumb” – informed by their good business instincts and many years of experience.  As the name implies, these “Rules of Thumb” are generally are a good guide.  But as the name also implies – not always.  The purpose of this article is to offer a few insights to business owners and executives to help them improve decision making related to the value of the speed of their cash flow.

A.  The Baseline – The Implied Value of 2% – 10, Net 30

There is perhaps no better endorsement of the inherent value of the speed of cash flow than this common billing convention.  And because it is so commonplace, we’ll use it as the basis for making our case.  Offering a full 2% discount on the price if payment is made in 10 days or less is a pretty large concession.  How large?  Believe it or not the annualized value is 36%.  (e.g. 2% discount for accelerating payment by 20 days – the difference between 30 days and 10 days; and 18 x 20 day periods in a year – 360 divided by 20; so 2 x 18 = 36%).  So fairly large indeed from our lens.

B.  The Rationale – How Can 36% Make Sense?

Actually it does make sense – in fact it often makes tremendous sense.  The following little example should make this point quite clear.  Suppose you sell a product for a margin of 10%.  If you sell that product once per month then you have earned a 10% margin 12 times during the year – or 120% annualized.  So you can think about it one of two ways 1) you offer a 2% discount on a 10% margin product and still earn a net margin of 8% on each sale, or 2) you could think about it in annual terms – which in the example above would imply 36% discount on a total annualized margin of 120% – or a net annualized margin of 84%.  As illustrated in part by the example, either way you think about, you always come out ahead so long as your margin on each sale is at least 2%.

C.  The Clarity – This Part Can Sometimes Be Counter Intuitive – But It’s True

When you offer 2% – 10, Net 30, you are doing 2 things very clearly.  Let’s take a look at both:

First – You are attempting to self finance your working capital needs (as opposed to borrowing from a third party) by offering a financial incentive for customers to pay early.

Second – You are placing an annualized value on the speed of your cash flow of 36%.

At first blush this may feel outlandish – who after all would pay 36% annually to finance anything?  Uncomfortable as it may feel to acknowledge, you can rest assured of at least two things: 1) the implied value of the speed of cash flow is – when offering 2% – 10, net 30 – in fact 36% annually – no matter how you slice it, and 2) it makes all the sense in the world to do in many, if not most, circumstances – as our example in B (above) helps to illustrate.   Which probably explains why it is so commonly offered.

D.  The Comparison – How To Use This Knowledge In Practice?

So are we suggesting that businesses stop offering 2% – 10, net 30 payment terms to their customers?  Hopefully it’s clear that our answer is “No”.  Unless, however, the business can borrow for less than 36% annually (or earns a margin of 2% or less).  Many business are able to borrow from traditional banks for interest rates (in this environment at least) meaningfully less than 36%.  This is terrific and we endorse it without qualification provided the business is otherwise a good candidate for borrowing.

Many small and medium businesses are not, however, able to borrow the money they need to grow from traditional bank sources.  For these companies the cost of borrowing will be higher.  So our counsel to them is simply this:  If you are (or would consider) offering 2% -10, net 30 payments terms, borrowing your working capital needs from a third party is in your financial best interest so long as you can 1) do so for less than 36% annually (hopefully much less) and 2) are otherwise a good candidate for borrowing.