When selling on credit, many firms offer discounts for early payment. Such discounts are offered primarily for two reasons. First, early payment by the customer enables the seller to have access to cash sooner. Second, the sooner an account is paid, the less opportunity there is for nonpayment.
Typical discount terms are 2/10, net 30.This indicates that a 2% discount will be granted if payment is made within 10 days of sale; otherwise, full payment is due within 30 days of sale.
These particular terms offer a significant inducement for early payment. To see this, consider the 2% to be a finance charge assessed for extending credit from the 10th to the 30th day after sale. That is, the customer must pay 2% more than otherwise required if payment is delayed for those 20 days. Because there are about 18 20-day periods in a year (365/20), the quoted discount implies an approximate annual interest rate of 36% (2% X 18), which is quite high relative to other sources of financing.