When I speak of the “cost of money”, I mean precisely that. Let me explain it here so you don’t get bored repeating the same definition every time I talk about it. All money has a cost
The money is being used to make you money or you have lost the opportunity for your money to make you money. Or at least to do everything I can to you.
If you are borrowing money to run your business, this money comes at a price. The price, of course, is the interest you pay on the money as you borrow it. If you have money that you have in the form of cash in a low-interest account or short-term investment, this money can cost you money too.
How? Simple. Let’s say you are in 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 will leave it in your business checking account or at a short-term liquid investment account. Let’s say you are earning 1/2% interest during this time.
It might seem that this money is working for you and 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 must ask yourself: is this the best place to do it? Is there any other use you can put this money to to earn more money?
For example, can you pay some bills ahead of time and get a 2% business discount? I’ll cover this in future articles, but for now think and understand that money comes at a cost. If your $ 50,000 stays in the bank earning 1/2% interest, you will earn $ 250 per year. Now I know that I have not factored compound interest, but I want to give a simple example of how I should think.
If you have the cash for 30 days, you will have made 1/12 of this $ 250 or $ 21. But what if you had used that $ 50,000 to pay the bills early and get a 2% discount? With a 2% discount on $ 50,000 it is $ 1,000. A simplistic example, no doubt, but even with this, it has significantly increased the return on your money.
Leaving your money in the bank came at a cost to you. A missed 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 in another way, you only have a limited amount to use and therefore the availability of cash must be considered.
Money has a cost. If I used $ 10,000 to pay an early bill that offered me a 1% discount, I have saved $ 100. If I used that same money to pay an early bill that offered me a 2% discount, I have doubled my return on it. I use that money, since I have saved $ 200.
Do you see my point? Now put aside any cash flow questions for a minute while I ask another
Now what if I didn’t pay any bills ahead of time, but put that $ 10,000 into an investment for 12 months paying myself 1%? Hasn’t it been good for me to earn $ 100 with my money? It seems so, but it is not.
By paying a bill early to take advantage of a prepayment discount, you will save much more than the discount. When you get a 2% discount by paying an invoice early, you get a much higher return than 2%. Unless you understand this, there will be no way that you can properly determine whether the best use of your money is to pay the bill and take the discount or not.
The formula is simple, so don’t despair. Here is the formula:
365 x discount rate
Annual effective interest = —————————————
Number of days that the payment must be
made before the expiration date to get this discount.
So if a provider offers you “2/10 net 30” terms, what is the effective interest rate? Ok first
of all, it offers you a 2% discount if you pay in 10 days. The 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 meet the 30-day terms.
For the sake of this example, let’s say the bill amount in question is the same $ 10,000 we’ve been talking about. This is what your formula looks like:
Annual effective interest = ————– = .365
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 paying discounted bills 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 find the most profitable option available to you at any given time.
Never forget that money has a cost. How you use it can make a big difference to your bottom line.