Cash Discounts: Doing the Math

20 Mar

Some companies today offer a discount on goods bought if the buyer pays within a certain time frame. These vendor discounts are believed to entice customers to pay quicker and making them less likely to default on their debts. But many companies wonder if the benefit of quick cash flow is worth the loss in revenue, and some aren’t sure what the discount is truly worth.calculator-385506_1280

So should you offer the discount if you’re a vendor? And should you take advantage of the discount if you’re a customer? For a vendor, it’s dependent on multiple factors, which we will go into in a moment. For a customer, if you have the money on hand it usually makes sense. For example:

Let’s say you are Customer ABC and you are going to pay an invoice from Vendor XYZ with terms of 2/10, net 60. A bit of math can tell you what paying early is worth to you:

The Effective Interest Rate = Discount % / (100-discount %) x 365 / (FT – DP)

FT: Full term in which the full invoice must be paid. DP: The discount period offered by the vendor

If we translate our invoice terms into the equation, we’ll get:

The Effective Interest Rate = 2/(100-2) x 365/(60-10)

The Effective Interest Rate = 2/98 x 365/50, which = 14.9%

This essentially translates to Customer ABC earning almost 15% on their money over that 50 day period (60 day full term minus the 10 day discount period). Take this math and apply it to your annual purchasing or sales numbers and you’ll be shocked at the potential money saved or wasted. With this there are also 2 pretty obvious rules that will yield a higher effective interest rate: a higher discount percent and a smaller spread between FT and DP

It’s very apparent that a buyer with enough cash on hand should definitely take advantage of these discounts whenever offered. However, there are several things to keep in mind when deciding whether or not to take advantage of a discount, or whether to offer one yourself.

  1. Cash on hand – if your cash flow is tight already, it probably isn’t worth it to take the discount. One banking overdraft fee can be more than the discount, and leave you in a worse position
  2. Interest rates – if you can earn 15% on your money by paying early and the bank is only charging 5% interest on loans, jumping through that one extra hoop can save you some extra money as well
  3. Margins – every business will have varying sales numbers and profit margins. For low-margin businesses (like grocery stores), offering even a 1% discount can really crush their bottom line. For high-margin businesses (like accounting or legal services), a larger discount is more easily affordable.
  4. Short- and long-term needs – if you’re a customer and have no use for current cash on hand, it absolutely makes sense to take the discounts. If you’re a vendor with a lot of money coming into the company 6 months from now, but could use the extra cash on hand now, offering the discount is one way to get through a difficult time.

As far as current trends go regarding cash discounts, one thing is consistent:  problematic customers will not start paying early. Whether they simply don’t have the cash on hand or their records are in disarray, it seems even offering a small discount to pay early won’t change their ways.

From our research, those customers who pay on time will usually pay a few weeks earlier to save some money. Unfortunately, those problem customers don’t find the discounts worth a dime. So when it comes time to consider offering a cash discount for prompt payment, think of your customers, your needs, and your reason for offering the discount. If you’re trying to get problem customers to pay, don’t waste your time.

Still have questions? Read more on payment terms here.

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