Does it make financial sense to take advantage of early payment discounts?
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.
What are early payment discounts?
Early payment discounts are discounts that a vendor or supplier offers to a customer if the customer pays their invoice or bill before the due date. This is an incentive for customers to pay their bills early, which helps vendors to improve their cash flow by receiving payment sooner.
For example, a supplier may offer a 2% discount on an invoice if the customer pays within 10 days of the invoice date instead of the standard 30 days. So, if the invoice is $1,000 and the customer pays within the 10-day period, they would only need to pay $980 ($1,000 - 2% discount of $20).
How does the math work for early payment discounts
Let's say your supplier is offering you a discount of 2% if you pay your invoice within 10 days, but if you don't pay within 10 days, you have to pay the full amount in 30 days. This type of discount is known as 2%/10 net 30.
If you decide to pay within 10 days, you will be sacrificing the use of your money for 20 days in exchange for a 2% discount. A 2% return over 20 days is actually quite impressive, and when annualized, it works out to be a 37% return. Even a smaller discount of 1%/10 net 30 works out to an 18% return when annualized.
In simpler terms, if you pay your invoice early, you will get a discount, which is like earning interest on your money. Even small discounts can add up to a significant return when annualized.
Should you invest or take a discount?
Keep in mind that 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 should you offer a discount?
What about offering early-payment discounts to your own customers? The math works in reverse and that means offering those discounts is very costly and rarely lucrative.
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.
Learn more about managing cash flow and improving cash conversion by downloading your free copy of BDC’s guide for entrepreneurs: Taking Control of Your Cash Flow.