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Extra Profits: The Magic of Purchase Discounts
Using purchase discounts is a recipe for success in any economy. A mix of “good business practices”, a pinch of “strengthening supplier relationships” and a portion of “profit” creates a dish that is sure to strengthen your bottom line. If your company isn’t already doing so, paying supplier bills early to take advantage of purchase discounts is a quick and easy way to get to the next level.
What is a purchase discount?
A purchase discount is money withdrawn when paying a supplier’s bill within a certain period. Discounts are usually expressed as a percentage, with 1% being the most commonly used and 0.5%, 1.5% and 2% all seen in standard practice. Thus, a $100 bill would cost your firm $99 only if the supplier offered a 1% discount and your accounting department paid the bill during the discount period. Most suppliers who offer credit terms allow payment of the bill within 30 days, expressed in business parlance as “net 30”. If a supplier offers a 1% discount to their customers for payment within 10 days, this would be expressed as “1% 10 net 30”. So, “1.5% 15 net 45” means the bill is due within 45 days, but the supplier will allow you to take a 1.5% discount if the bill is paid within 15 days.
Another deviation is to express credit terms as dates on a calendar. Thus, “2% 5th net 25th” means the bill is due on the 25th of the month but a 2% discount is given if the bill is paid by the 5th of the month.
Would you invest your company’s money for an 18% return?
A particular argument against taking advantage of discounts on purchases is the cash value. You can argue that keeping cash in your company for a long time outweighs the 1% of the purchase discount. The math shows otherwise. For example, take the most common credit terms of 1% 10 net 30. Remember, this gives you a 1% discount for paying 20 days earlier in the cycle. Note, however, that banks quote their returns based on the annual percentage yield (APY) rate, not the 20-day rate. The calculation of holding a 20-day investment in terms of APY begins with dividing the investment by a period of 360 days (known as a banker’s year). The simple quotient of 360/20 equals 18, indicating that the real discount is 18 times its face value. So, a discount rate of 1% yields the equivalent of 18% APY.
How can your company afford it?
The beauty of taking advantage of shopping discounts, if you’re not already doing so, is how easy it is to start. Think about how you will do business now. Most likely, the accounting department pays its suppliers every month. Don’t change it! Pay them every 30 days – Start paying during the grace period. As an example: if your supplier offers 1.5% 7th net 27th credit terms, you will normally pay by the 27th of each month, assuming you run a reputable business. Then the payment will be submitted again in another 30 days on the 27th and so on, month after month. Use the purchase discount by paying on the 7th of each month instead of paying on the 27th of each month. The first time will be a bit difficult as you will have to pay on the 27th of this month and then about 10 days later on the 7th of the next month. But, this is a one-time procedural change. After this short-term pain, you’ve realized long-term gains for your firm. What’s more, your company is back on a monthly payroll schedule, now paying on the 7th of each month instead of the 27th.
While borrowing from a line of credit or credit card should only be used as a last resort, you should ask yourself whether it’s worth paying 4.75% APR (average credit line rate) or 12% APR (average credit card rate) to save 18%. . APY.
Are credit terms negotiable?
Credit terms are fully negotiable! Based on your volume and supplier loyalty, you can negotiate a special discount rate for your company. A 3% discount is incredibly rare. A 2% discount, however, is not out of the question for very loyal customers. You won’t know unless you ask!
Why do suppliers offer discounts?
Cash is king in every business, not just yours. Suppliers are also businesses. They need cash to prepare salaries, pay water bills and keep the lights on. Their cash flow model is further complicated by going out of business, declaring bankruptcy or not paying on time. Therefore, they are willing to insure your company to deposit cash into their bank accounts so they can pay their bills.
How do shopping discounts generate profits?
According to accounting rules (commonly known as generally accepted accounting principles, or “GAAP”) the purchase discount is the ‘top line’ number and is counted as revenue. Unlike other income, however, every penny of purchase discount income goes directly to the ‘bottom line’, known as net profit. It doesn’t take an accounting degree to understand this phenomenon.
In very simple terms, from your company’s current income statement (aka profit and loss statement), the dollar flow is as follows. Revenue from your clients (the ‘top line’). Direct costs, such as labor and materials, are deducted from revenue to arrive at gross profit (‘breakeven’). Indirect costs, such as cell phones, lights, insurance, office staff, etc., are deducted from gross profit to calculate net profit (‘bottom line’).
Keeping the above in mind, add the additional revenue stream of purchase discounts to the income statement as revenue. Paying suppliers early does not create additional direct costs; Therefore, it goes from the direct cost part of the statement to gross profit. Similarly, paying early does not incur additional indirect costs; Therefore, the purchase discount amount goes directly to the net profit line.
How much profit?
Even small companies can count their additional profits in the thousands of dollars with this simple change in payment strategy. It is not unusual for a small firm of 10-20 employees to have annual revenue of $1 million. Since content averages 40% of revenue in most industries, your company’s average annual content spend will be around $400,000. Thus, a 1% discount on purchases for an entire year returns $4,000 in new found profits! If your material purchases are high or the discount rate you negotiate is good, the impact on the bottom line will be huge. Additionally, when you consider that this “once hidden, but now found” money is generated by a one-time, 20-day change in payment policy each year, the results are staggering. As an added bonus, your suppliers will quickly move you up a few spots on their “Best Client List.”
A simple improvement in using purchase discounts today will see your company generate additional profits, strengthen supplier relationships, and leverage corporate best practices for years to come.
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