What Is a Cash Discount?
Cash discounts refer to an incentive that a seller offers to a buyer in return for paying a bill before the scheduled due date. In a cash discount, the seller will usually reduce the amount that the buyer owes by either a small percentage or a set dollar amount.
Key Takeaways
- Cash discounts are deductions that aim to motivate customers to pay their bills within a certain time frame.
- A cash discount gives a seller access to her cash sooner than if she didn’t offer the discount.
- An example of a cash discount is a seller who offers a 2% discount on an invoice due in 30 days if the buyer pays within the first 10 days of receiving the invoice.
Understanding Cash Discounts
Cash discounts are deductions allowed by some sellers of goods, or by some providers of services, to motivate customers to pay their bills within a specified time. Cash discounts also are called early payment discounts.
The sellers and providers offering a cash discount will refer to it as a sales discount, and the buyer will refer to the same discount as a purchase discount.
Cash Discount Example
An example of a typical cash discount is a seller who offers a 2% discount on an invoice due in 30 days if the buyer pays within the first 10 days of receiving the invoice. Giving the buyer a small cash discount would benefit the seller as it would allow her to access the cash sooner.
The sooner a seller receives the cash, the sooner she can put the money back into her business to purchase more supplies and/or grow the company in other ways. The amount of the cash discount is usually a percentage of the total amount of the invoice, but it is sometimes stated as a fixed amount.
A typical format in which the terms of a cash discount could be recorded on an invoice is Percentage discount [if paid within xx days] / Net [normal number of payment days].
Thus, if the seller is offering a reduction of 2% of the amount of an invoice if it is paid within 10 days, or normal terms if paid within 30 days, this information would appear on the invoice as “2% 10 / Net 30.”
There are many variations on the terms of cash discounts, which tend to be standardized within a particular industry.
Why Might a Seller Give a Cash Discount?
A seller might offer a buyer a cash discount to 1) use the cash earlier, if the seller is experiencing a cash flow shortfall; 2) avoid the cost and effort of billing the customer; or 3) reinvest the cash into the business to help it grow faster.
Cash discounts can benefit a provider of goods or services by giving her the cash sooner than she normally would get it. In turn, this cash could help her to grow the business at a faster pace while saving on administrative expenses, for example.
In the first instance, we all have experienced being short of cash; the seller may need the cash to pay one of her own bills on time, for instance. In the second reason cited above, not only can billing be a time-consuming administrative function, but it also can be an expensive one. Most businesses that are large and successful do not even think about this. A startup company or a young professional, however, might be trying to rein in their costs for labor and supplies.
Consider a young doctor who is launching a private practice. The doctor offers patients a 5% cash discount if they pay for his services on the day of the appointment. Although it may seem like the physician could lose money by letting his patients pay less, he is actually reaping huge savings by avoiding the administrative costs of billing, mailing statements for unpaid amounts, processing partial payments, not collecting amounts owed, and so on.
Similarly, in the third instance, startups and young professionals can often use infusions of cash to help grow their businesses faster.
Cash Discount and Cash Conversion Cycle
If used properly, cash discounts can improve a business’s cash conversion cycle (CCC). The cash conversion cycle is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flow from sales.
The CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash. The metric includes the amount of time needed to sell inventory, collect receivables, and the length of a company’s bill payment window before the company begins to incur penalties.
Receiving a cash discount at any stage of its CCC could help make the company more effective and shorten the number of days it can take to convert its resources into cash flows.
The cash conversion cycle can be particularly helpful for analysts and investors who wish to draw a relative-value comparison between close competitors. Combined with other fundamental ratios, such as the return on equity (ROE) and return on assets (ROA), the CCC helps to define a company’s overall viability. For example, the CCC may foretell the effectiveness of its management team. The CCC can also highlight a company’s liquidity risk by measuring how long a firm will be deprived of cash if it increases its investment in resources.
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