One of the problems of offering net-30 terms (or longer) to customers is that it can create cash flow problems. Many companies provide payment discounts to clients to improve their cash flow. In this article, we discuss how early payment discounts work and how to offer them to clients in an effective manner. We cover:
- What is an early payment discount?
- How to use them effectively
- Pros and cons
- An alternative
- Cost comparison
- Build a cash reserve
1. What is an early payment discount?
Most commercial sales happen on net-30 to net-60 terms. These terms give customers 30 to 60 days to pay an invoice. However, offering payment terms also affects the working capital of your company. This situation can create a financial problem for companies with low cash reserves.
A simple and effective way to improve your cash flow is to offer early payment discounts to customers. This strategy allows the customer to pay an invoice early to get a discount. The discount increases their profits and is an excellent incentive for customers with available funds. Companies that don’t take advantage of the discount pay the invoices on their usual terms.
2. How to offer early payment discounts effectively
An early payment discount is noted on the invoice where you list the terms. It’s easier to understand how to annotate the invoice by looking at an example. Assume a customer that gets net-30-day terms now has the option to get a 2% discount if they pay in ten days. This would be noted as “2%/10 Net 30” on the invoice. The first part shows the discount terms, and the second part shows the standard terms. The discount and terms can be negotiated and vary by customer. Here are some typical discounts and terms:
- 1%/10 Net 30
- 2%/10 Net 30
- 2%/10 Net 45
Some companies make the mistake of offering all their customers a discount for early payment. There are two reasons why this strategy does not work well.
The first reason is that offering the discount has a direct cost to your company. Your profitability suffers. Consequently, it’s to your advantage to provide this incentive only to enough customers to meet your financial needs. The second reason why offering this incentive to every customer does not work well is that they can be abused. Unfortunately, some clients may take the discount and still pay on their usual terms. This situation leaves you worse off financially.
Instead, we suggest you give this benefit to your customers with the best commercial credit. You can always verify a company’s credit through Dun and Bradstreet or Equifax. These clients always tend to pay on time and never miss a payment.
3. Pros and cons
In general, providing discounts for early payments to select clients is a strategy that works well. It extends an important benefit to select clients while also improving your cash flow. However, offering discounts has some disadvantages that are often overlooked.
a) They are unpredictable
The early payment discount allows customers to pay in ten days. However, it’s only an option. Customers may choose to pay on their usual terms without the discount. This variability makes these payments somewhat unreliable, especially during challenging economic times.
b) They can be abused
Early payment discounts can be abused by aggressive or less-than-scrupulous customers. Basically, they take the discount but still pay on their usual terms or later. This scenario leaves you with little recourse unless you want to have a dispute with your customer.
c) Clients can use them to renegotiate terms/contracts
Some clients with aggressive vendor management departments may use your offer as leverage to renegotiate your contract pricing later on. They may try to make the discount permanent without paying early.
4. An alternative
Companies whose cash flow problems are not serious should be able to use early payment discounts to improve their finances. Companies that need reliable cash flow should consider using financing.
Invoice factoring is a financing solution used by companies that need to improve cash flow issues created by slow-paying clients. It works by financing your accounts receivable, providing your company with immediate working capital.
Factoring has several advantages over other options, can be deployed in a few days, and is available to small companies. The cost of financing your invoices is based on your industry, volume, and general risk. The cost ranges from 1.5% to 4.5% per 30 days. To learn more, read “What is Factoring?” and “How Does Invoice Factoring Work?”
5. Cost comparison
Accurately comparing the cost of factoring vs. providing early payment discounts can be challenging. Both options are more expensive than a bank line of credit of comparable size. However, this type of comparison is practical only if your company can qualify for a line of credit.
A more practical approach, especially for small businesses, is to compare the cost in dollars of each solution. Build a model of how much each solution would cost your company based on your use and customer payment patterns. Ultimately, the decision will depend on whether your profit margins support these options and whether your business benefits from using them.
Consider the following example. The following list shows the average cost of offering early payment discounts and the costs of three different factoring plans. Note that the costs are not intended to be representative of current prices. Instead, they are designed to give you an idea of how factoring terms are typically offered.
- Early payment discount – 2%/10 Net 30
- Factoring (A) – 1% per 15 days
- Factoring (B) – 2% flat fee
- Factoring (C) – 1% per 10 days
a) Which option is best?
There is no easy answer to this question, as it depends on how urgently you need funds. It also depends on the factoring terms you can negotiate with the financing company. If your company’s cash flows are tight, but operations are not at risk, offering the early payment discount may be the best alternative. There is a chance a customer could decide to pay in 30 days. However, this risk may be acceptable if your situation is not challenging.
On the other hand, the situation is different if your company needs funds to make payroll or cover other expenses. Financing may be your best option since it provides immediate funds. Let’s look at each alternative in more detail.
Factoring plan A has a rate that increases by 1% every 15 days. It’s cheaper than the early payment discount for customers who pay in less than 15 days. It has the same cost as the early payment discount for customers who pay in more than 15 days but less than 30 days. After that 30-day period, factoring becomes incrementally more expensive.
Factoring plan B offers a flat 2% rate. Flat rates are typical of factoring plans in the transportation industry. Arguably, this pricing model could be considered the best option since the cost is the same as an early payment discount. You miss out on savings when clients pay quickly, but you avoid the extra costs if they pay slowly.
Lastly, factoring plan C shows a common rate structure for a small business. The rate increases by 1% every ten days. This plan is cheaper than an early payment discount in the first ten days of the invoice. The cost becomes the same for invoices that pay in more than ten days but less than 20 days. It becomes incrementally more expensive after 20 days.
b) Evaluate trade-offs
Compare each alternative’s cost against your customers’ payment patterns and your cash flow needs. The best course of action is to look at the available options, determine the advantages and disadvantages of each, and choose the one that works best for your company.
6. Build a cash reserve
Small companies should consider building a cash reserve. The reserve allows them to cover expenses without relying on external financing or early payment discounts. Building a cash reserve is simple but takes discipline and time. However, a well-funded cash reserve is the best way to avoid cash flow problems.
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