Cash discount

Cash discount
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Methods and techniques

Cash discount is offered by seller to motivate buyer to pay at specified time (e.g. before the deadline). Depending on the side of the transaction it can be also known as sales discount or purchase discount or early payment discount.

Usually the cash discount is offered when the payment is deferred in time in order to shorten that time. However, it can be also offered for instant payment instead of deferred one.

The cash discount is profitable for the seller as he/she obtains the money earlier and can use them for other purposed. It also can decrease risk (instant payment) and cost of debt collection. The cash discount decreases cash conversion cycle, as customers pay faster. That can improve balance sheet in short term. Because cash is worth more when we receive it in advance, the creditor is willing to give the customer the incentive to pay in a short time. In this way, the creditor offers its clients special loan terms for an earlier payment. We express the cash discount as a percentage deducted from the amount due for the invoice. For example, 3/10, n / 30 is a very common sales term which we read as three net thirty. Three tens mean that 3% of the invoice will be deducted when the customer pays the invoice within 10 days from the date of its issue. Net thirty tells us that the total amount due for the invoice has to be paid up to 30 days.

Costs and advantages of a cash discount[edit]

Many companies believe that it is worth the cost and offer the customer a cash discount for receiving an earlier payment (e.g. 1% discount for making payments within 10 days). The company must consider whether such a policy is necessary (to maintain or increase its market share or compete with other companies) and cost-effective, and next determine for what period of time and what percentage discount they can offer. Analyzing both the costs and benefits of a cash discount, we can consider whether they are good or not for our company.

Mobilizing customers for faster payment by cash discounte has such advantages as:

  • Limiting bad debts,
  • Limited investment in receivables,
  • Diminution expense of carrying accounts receivable,
  • Accelerate the cash flow of the company,
  • Reduction of the medium collection period.

Offering a cash discount also carries such costs as:

  • Expense of cash discount (unless the cost has already been contained in the pricing structure),
  • The costs of monitoring for unauthorized non-compliance,
  • The processing costs that are necessary to ensure that the customer gets the right chunk in cases such as partial payments, small purchases, etc.,
  • Revenue plan, that's mean expectations regarding revenue and sales. [1].

Resignation of a cash discount[edit]

Formula:

PD- received cash discount expressed as a percentage

ND- delay in cash discount expressed in days

365- number of days in a year

\(\frac{PD}{1-PD} \cdot \frac{365}{ND} \)

Example:

It happens that the discount is not beneficial for the company, then you should think about giving up the cash discount and borrowing cash for the actual interest rate. To show how to evaluate the impact of cash discount, let's take a look at the example of suppliers with different credit terms. Supplier 1 has terms: 2/10 net 40, supplier 2 has terms: 3/10 net 60.

Supplier 1: 2/10 net 40

\(\frac{0,02}{1-0,02} \cdot \frac{365}{40-10}= \frac{0,02}{0,98} \cdot \frac{365}{30}=0.0204 \cdot 12,1667= 24,82 \% \)


Supplier 2: 3/10 net 60

\(\frac{0,03}{1-0,03} \cdot \frac{365}{60-10}= \frac{0,03}{0,97} \cdot \frac{365}{50}=0,0309 \cdot 7,3= 22,55 \% \)

If the company has the option of borrowing funds in the amount of 23%, it would be suggested not to use the cash discount from supplier 2, because lending money at 23% interest costs would exceed the cost of financing. However the second supplier a cash discount should be applied because its cost is greater (24.82%) than the expense of financing (23%) [2].

References[edit]

Footnotes[edit]

  1. Reider,R., Heyler,P.B. (2003)
  2. Rachlin R., (1997)

Author: Natalia Windys