Early payment discounts—more valuable than you think
Read time: 3 minutes
Businesses often offer discounts to customers who pay their bills early. Does it make financial sense to take advantage of these discounts?
The answer is usually yes. They can actually be very lucrative for your business and justify using your extra cash or borrowing to take advantage of them.
But they’re not good for all businesses. Whether they are a good idea for your company depends on a few factors, such as your return on investment, financing costs and cash flow.
Here’s how to figure out whether it’s worth taking a discount for early payment—and whether it makes sense for you to offer one to your own customers.
37% annualized return
Let’s say your supplier offers a 2% discount for paying an invoice in 10 days. Otherwise, the full amount is due in 30 days. This common discount is known as 2/10 net 30.
If you pay in 10 days, it means you’re giving up use of your money for 20 days in exchange for 2% off. A 2% return over 20 days turns out to be pretty impressive. It works out to a 37% return when annualized.
Even a 1%/10 net 30 discount works out to an 18% return when annualized.
Right for your business?
But the discounts aren’t always worth taking. You have to weigh them against your return on investment, cost of financing and cash flow.
If you earn less than 37% from an investment in your business or pay less to service your debt, you’re best off taking a 2%/10 net 30 discount.
But if your investment return is above 37% (which can be the case especially for some start-ups), then taking the discount doesn’t make financial sense. You could earn more putting the money to work in your business.
Similarly, in the unlikely event that your cost of financing is above 37%, taking the discount isn’t a good idea. You’re better off paying down your debt.
Cash flow is another important consideration. If cash on hand is tight, you should take a pass, even if your financing cost or investment return is above 37%.
When to offer a discount
What about offering early-payment discounts to your own customers? The math works in reverse and that means offering them is very costly.
Your own return on investment or financing cost would have to be above 37% for it to make sense to offer a 2%/10 net 30 discount on an invoice. It would have to be above 18% for it to make sense to offer a 1%/10 net 30 discount.
Thus, unless your business is experiencing cash flow problems or the return on investment of the business is very high, it’s probably not a good idea to offer a discount for early payment, says BDC Business Consultant Jorge Henao, an expert on financial management.
Probably not worth it
“If your customer is paying you within 30 days, it most likely doesn’t make sense from a financial point of view,” Henao says. “As well, if you decide to stop giving the discounts, it might encourage your customers to start paying late.”
To learn about more about cash flow management and read real-life entrepreneur stories, download your free copy of BDC’s eBook Master Your Cash Flow: A guide for entrepreneurs.