Early payment discount
An early payment discount reduces the invoice amount when the buyer pays before the standard due date. Typically expressed as terms like "2/10 Net 30," where 2% discount is available if paid within 10 days, otherwise full payment is due in 30 days. These discounts can provide significant returns that often exceed conventional financing costs.
Examples
2/10 Net 30 terms: An invoice for $10,000 under 2/10 Net 30 terms can be paid as $9,800 if paid within 10 days, or the full $10,000 if paid within 30 days. The 2% savings for paying 20 days early annualizes to roughly 36% return.
1/15 Net 45 terms: A supplier offers 1% discount for payment within 15 days, otherwise full payment in 45 days. The decision to take the discount depends on the company's cost of capital and cash availability.
Selective discount capture: A company analyzes all supplier discount terms, prioritizing payment to capture discounts offering the best annualized returns when cash is limited.
Definition
Early payment discounts represent a financing arrangement. The supplier effectively offers a loan at an implied interest rate: the discount amount is interest, and the discount period to standard terms is the loan period. Annualized, common discount terms often exceed 20-40% return.
The decision to take early payment discounts depends on the company's cost of capital. If the discount's annualized return exceeds the company's borrowing cost or investment return, taking the discount makes financial sense. Many discounts offer returns that significantly beat alternative uses of cash.
Capturing discounts requires efficient invoice processing. If processing takes most of the discount period, discounts may be missed not because of cash constraints but because of process limitations. Efficient accounts payable processes enable discount capture.
Dynamic discounting programs offer sliding-scale discounts based on actual payment timing, providing flexibility beyond fixed discount terms. Supply chain financing programs may also facilitate early payment to suppliers while optimizing buyer cash flow.
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