When I talk about the “cost of money” I mean precisely that. Let me explain it here so that I don’t bore you by repeating the same definition every time I talk about it. All money has a cost
The money is used to make you money or you have lost the opportunity for your money to make you money. Or at least to do as much to him as he could.
If you are borrowing money to run your business, this money comes at a price. The price, of course, is the interest you are paying on the money as you borrow it. If you have cash in a low-interest account or a short-term investment, this money may be costing you money, too.
As? Simple. Let’s say you are in a good cash flow situation and have a cash balance of $50,000. You know this money will be needed for operating expenses in the near future, so you let it sit in your business checking or short-term liquid investment account. Let’s say you are earning 1/2% interest during this time.
It may seem like this money is working for you, making you money, and in fact it is. But the question is whether or not this is the most effective use of that money. If your money is in one place, it cannot be in another at the same time. Obvious right? Well, if your money is tied up in the bank, you have to ask yourself: is this the best place to do it? Is there another use that you could give this money to earn more money?
For example, can you pay some bills early and get a 2% trade discount? I will cover this in future articles, but for now think and understand that money has a cost. If your $50,000 sits in the bank earning 1/2% interest, you’ll earn $250 per year. Now I know I haven’t accounted for compound interest, but I want to give a simple example of how you should think.
If you have the cash sitting around for 30 days, you will have earned 1/12 of this $250 or $21. But what if you had used that $50,000 to pay bills early and get a 2% discount? A 2% discount on $50,000 is $1,000. A simplistic example to be sure, but even using this you have significantly increased your return on money.
Leaving your money in the bank had a cost to you. A lost opportunity cost. An opportunity to use this money to earn more money. But you have to consider your cash flow, no matter how effectively you can use your money, you only have a limited amount to use and therefore cash availability must be considered.
Money has a cost. If I have used $10,000 to pay a bill early that offered me a 1% discount, I have saved $100. If I used that same money to pay a bill early that offered me a 2% discount, I have doubled my return on the use of that money as I have saved $200.
Do you see my point? Now put aside any cash flow questions for a minute while I do another one.
spot.
Now, what if I don’t pay any bills early, but instead invest that $10,000 over 12 months paying myself 1%? Didn’t it go well for me to win $100 with my money? It would seem so, but it is not.
By canceling an invoice early to take advantage of an early payment discount, you’ll save much more than the discount. When you get a 2% discount by paying an invoice early, you’re getting a much higher return than 2%. Unless you understand this, there is no way you can correctly determine whether or not the best use of your money is to pay the bill and take the discount.
The formula is simple, so don’t despair. Here is the formula:
365 x discount rate
Annual effective interest = —————————————
Number of payment days must be
made before the expiration date to obtain this discount.
So if a provider offers you “2/10 net 30” terms, what is the effective interest rate? ok first
After all, he is offering you a 2% discount if you pay within 10 days. Normal terms are 30 days. This
means that to get the 2% discount you must pay 20 days before.
For this example, we assume that you would normally comply with the 30-day deadlines.
For the sake of this example, let’s say the invoice amount in question is the same $10,000 we’ve been talking about. This is what your formula looks like:
365x.02
Effective annual interest = ————– =.365
twenty
Its effective annual interest rate is 36.5%. Obviously, even if you were to borrow the money to pay this bill, your rate of return will be worth it.
Don’t think I’m suggesting discounted bill pay as the only option you want to consider. I have simply chosen this often overlooked strategy as an example.
You should always consider all of your options for using your money. The goal is to search for the most profitable option available to you at any given time.
Never forget that money has a cost. The way you use it can make a big difference in your results.
