Early payment discounts, sometimes called settlement discounts, are a common way businesses try to improve their cash ﬂow. If you’re having cash ﬂow issues, 30 to 60 days can be a long time to wait for payments – so in some instances, companies adopt early payment discounts of one or two per cent of the bill in exchange for paying within the ﬁrst 10 days of receipt. While it sounds like an elegant solution to the problem, it can actually have unforseen consequences for your business, so early payment discounts should be considered carefully as an option before you decide they’re right for you.
Advantages and Disadvantages of Early Payment Discounts
As mentioned above, early payment discounts may be a way to encourage your client to pay early when you’re struggling with cash ﬂow problems. You can have uniform payment terms for all of your invoices, while encouraging clients who can make early payments to do so. It’s a way to have more working capital available when you need it, and if the reduction in proﬁt is worth having cash on hand sooner rather than later, it makes sense to oﬀer it.
However, early payment discounts may not appeal to all clients – while it usually makes ﬁnancial sense to take the oﬀer, some companies may not take advantage of the oﬀer because the use of their money over the remaining 20 days is more valuable than the 2 per cent discount. Additionally, some clients may agree to pay within 10 days to receive the discount, then pay later at the discounted rate – or worse, take it as a sign that you’re willing to renegotiate your contract at a discounted rate on a permanent basis.
First of all, take a look at your proﬁt margin to decide whether or not early payment discounts are right for you. If you don’t already know what it is, subtract all labour, expenses, and overhead costs from the total you’re invoicing to come up with your proﬁt. Then, calculate what your proposed discount would be. For example, if you’re invoicing a client $1,000 and oﬀering a 2% discount, they would have the opportunity to take $20 oﬀ of the invoice. However, if your proﬁt margin is 10%, you’re only making $100 oﬀ the invoice in the ﬁrst place – so you would be reducing your proﬁt to $80 for the invoice.
Secondly, think about interactions you’ve had with clients in the past. Do you have clients you can trust not to take advantage of the discount without honoring the payment terms? If you’re taking a risk, make a plan for how you will deal with the situation calmly and profesionally.
Finally, weigh early payment discounts over other options for improving cash ﬂow, including borrowing money and selling assets if necessary. If the interest that you are likely to pay on a small loan will cost less than discounting your invoices, it may make more ﬁnancial sense to take out the loan instead. Keep in mind that while early discounts may entice some clients to pay sooner rather than later, there’s no guarantee they will – so if you are in dire straits, it may be better to choose an option like borrowing or selling assets that will ensure you have cash.
How to Offer Early Payment Discounts
Since there are many ways early payment discounts can go awry, it’s a good idea to be selective about which clients you oﬀer them to. Ideally, you’d oﬀer them to good clients who simply pay later than you would like them to, to minimize the potential for disagreements down the road. It’s advisable to notify these clients of the change in terms before their invoice arrives so they don’t miss out if they want to take advantage of it. You can also use early payment discounts to help foster client loyalty by letting them know you’ve selected them for the special oﬀer because they are a longstanding customer.
How to Specify Early Payment Discounts on Invoices
When it’s time to compile their invoice, the payment discount should appear in front of the payment terms in the form A/B, Net C, where A is the percent discount they would receive, B is the number of days it’s valid for, and C is the number of days the client has to pay the invoice at full price. So for example, the shorthand for a 2% discount for 10 days after the invoice has been issued would read “2/10 Net 30.” The total of the invoice should still be for the full amount – if the client pays early, they can simply prepare a payment for the discounted amount and you can make adjustments in your ledger to balance it out.
Accounting Entries for Early Payment Discounts
If the client does pay early to receive the discount, you’ll to make an entry under your Sales Discounts ledger account along with the entry under Cash to balance the receivables. If you’re using accounting software, the program will register their early payment discount automatically – you just need to set the client up for early payment discounts in your contacts.
You’ll have to do a bit of planning to ﬁgure out whether early payment discounts are right for your business and if so, how to execute them properly. As with any new undertaking, it’s best to proceed with caution – but they are a solution if you’re struggling with cash ﬂow, and accounting software like Billomat can help make it an easier one to manage.