How Do You Calculate Operating Cash Flow From Income Statement Extra Profits: The Magic of Purchase Discounts

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Extra Profits: The Magic of Purchase Discounts

Using discounts when shopping is a recipe for success in any business. Mixing a scoop of “good business practice”, a pinch of “strengthening supplier relationships” and a heaping helping of “profit” creates a dish sure to fatten your bottom line. If your business isn’t already doing this, paying your suppliers early enough to take advantage of discounts on purchases is a quick and easy way to get to the next level.

WHAT IS A PURCHASE DISCOUNT?

Discount when purchasing is money that is deducted from the supplier’s account when paying within a certain period. Discounts are usually expressed as a percentage, with 1% being the most commonly used, and rates of 0.5%, 1.5% and 2% being encountered in standard practice. So a \$100 invoice would only cost your company \$99 if the vendor offered a 1% discount and your accounting department paid the invoice during the discount period. Most suppliers who offer credit terms allow invoices to be paid within 30 days, which is expressed as “Net 30” in business jargon. If a supplier offers a 1% discount for their customers to pay within 10 days, this would be expressed as “1% 10 Net 30.” So “1.5% 15 Net 45” means the bill is due in 45 days, but the supplier will allow you to take 1.5% off the bill if you pay within 15 days.

Another deviation is the expression of credit terms as a calendar date. So “2% 5th Net 25th” means the bill is due on the 25th of the month, but a 2% discount is offered as long as the bill is paid by the 5th of the month.

WOULD YOU INVEST YOUR COMPANY’S MONEY FOR 18% RETURN?

A typical argument against taking advantage of a purchase discount is the cash value at checkout. You can argue that keeping cash in your company for longer far outweighs the stingy 1% that the purchase discount generates. The math shows otherwise. Take for example the most common loan terms of 1% 10 Net 30. Remember, this gives you a 1% discount for paying 20 days early in the cycle. Note, however, that banks quote their returns based on the annual percentage rate of return (APY), not the 20-day rate. The math for putting a 20-day investment into APY starts with dividing by a period of 360 days (known as a banking year). Simply dividing 360/20 equals 18, which shows that the actual discount is “worth” 18 times the face value. So a 1% discount rate gives the equivalent of an 18% APY.

HOW CAN YOUR COMPANY AFFORD IT?

While borrowing from a line of credit or credit card should only be used as a last resort, you have to ask yourself if it’s worth paying 4.75% APR (average line of credit rate) or 12% APR (average credit card rate) to save 18% APY .

IS AN AGREEMENT POSSIBLE ON CREDIT TERMS?

Loan terms are absolutely negotiable! Based on your volume and vendor loyalty, you may be able to negotiate a special discount rate for your business. A 3% discount is incredibly rare. A discount of 2% is not out of place for extremely loyal customers. You won’t know until you ask!

WHY DO SUPPLIERS OFFER DISCOUNTS?

Cash is king in any business, not just yours. Suppliers are also companies. They need cash to pay salaries, pay water bills and keep the lights on. Their cash flow model is further complicated by the number of companies that go out of business, declare bankruptcy or simply don’t pay on time. They are, therefore, willing to offer your company an incentive to ensure that cash flows into their bank accounts in order to pay their bills.

HOW DO PURCHASE DISCOUNTS GENERATE PROFIT?

According to accounting rules (known as: Generally Accepted Accounting Principles, or “GAAP”), purchase discounts are a ‘top line’ number and are treated as revenue. However, unlike other income, every penny of purchase discount income flows directly to the ‘bottom line’, known as net profit. You don’t need a degree in accounting to understand this phenomenon.

Very simply put, from your company’s current profit and loss statement (AKA Profit and Loss Statement), the dollar flow is as follows. Income is generated from your clients (‘top line’). Direct costs, such as labor and materials, are subtracted from revenue to arrive at gross profit (the ‘bottom line’). Indirect costs, such as mobile phones, lighting, insurance, office staff, etc., are deducted from gross profit to calculate net profit (the ‘bottom line’).

With the above in mind, add the additional income stream from the purchase discount to the income statement as income. There are no additional direct costs generated by early payment to suppliers; so that flows through the direct cost section of the report to gross profit. Similarly, there are no additional indirect costs incurred by early payment; so that the amount of the purchase discount flows straight into the net profit line.

HOW MUCH PROFIT?

Even small businesses can measure their additional profits in the thousands of dollars with this simple payment policy change. It is not uncommon for a small business of 10-20 employees to have an annual revenue of one million dollars. Since materials account for an average of 40% of revenue in many industries, your company’s average annual materials costs will be around \$400,000. So a 1% discount on purchases all year returns \$4,000 in newfound profits! If your material purchases are larger or if the discount rate you negotiate is better, the impact on the bottom line would be much greater. Plus, when you consider that this “once hidden, now found” money is generated year after year by a one-time, 20-day payment policy change, the results are astounding. As an added bonus, your vendors will quickly move you up a few spots on their “best client list.”

One simple improvement to get a discount on your purchase today will allow your company to earn additional profits, strengthen relationships with suppliers and use company best practices for years to come.

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