Accelerate Cash Flow: Offer an Early-Pay Discount?

When it comes to collecting trade receivables, time really is money. Statistics show that once a receivable is 120 days past due, there is a 20% chance that it will never be collected.  The collection rate erodes further as additional time goes by. As we have shown elsewhere in this issue, policy changes that speed the turning of receivables into cash can generate immediate, permanent and, in some cases, substantial tax-free cash flow.

A good place to start may be by offering your customers an incentive for early payment of invoices. Offering a 1% discount on the total invoice amount if payment is received within 10 days and your typical terms are net 30 days, would be referred to as “1/10, net 30.”

How to analyze the cost or savings of offering an early-pay discount

First, answer these three questions: What does it cost your company to borrow for short-term needs? For our example, let’s assume 8.5% annually. What is the risk of non-collection on receivables due from companies that you expect to take advantage of the early-pay discount offer? For our example, let’s assume our average annual bad-debt expense is 2% of revenues, but that our answer to this question is 1.5%, because we expect that customers who take the early-pay option will be the more financially stable ones. How many days sooner will the “early payers” pay? Let’s assume 35 days.

Now calculate your discount rate by adding your annual borrowing rate (8.5%) to the estimate of what your annual losses would be on regular receivables due from early-pay customers (1.5%). The answer for our example is 10%. Next, calculate the daily rate by dividing the discount rate by 365, then multiply the result by the days saved (35 for our example). The answer for our example is 0.009589%. This means that if we want to break even financially by offering the early-pay discount, we should offer only a 0.96% (basically 1%) discount on each invoice. If we round this number up to 1%, we can surmise that the proposed policy would have little effect economically. But some other things should be considered.

First, the early-pay option may be of significant value to certain customers or prospects. As such, it could help you win business. Second, consider the time, effort and money spent on collecting receivables. Although this burden is real, we did not factor this savings into our analysis above. Third, a case could be made to use a much higher cost of capital. This argument is based on the fact that long-term capital, debt and equity can cost 15% or more on a blended basis. If the proposed policy change generates a permanent cash impact, the long-term cost of capital should be used and would justify a higher early-pay discount.

To implement: Simply print a notice prominently on each invoice that the customer may take a certain percentage off if he or she pays within the early-pay period. Announce the new policy to the appropriate authority at your customer’s company, too.

Warning: Before you implement an early-pay discount, decide how you will respond if a vendor takes the discount but does not pay early. What if your largest vendor does this? As with any rule or policy, it is only of value if enforced. We recommend that when you announce your new early-pay discount policy, make it clear when and how the discount will be earned and applied. It should be earned when payment is received within the specified period and the discount is requested with the payment. If a discount is taken but payment is not received within the allotted time, immediately notify the vendor of the failure to qualify and the outstanding amount. The longer you let the issue wait, the harder it will get to be paid.

Here’s the calculation:

Current annual rate of interest incurred on short-term borrowing: 8.5%

Annual percentage collection loss on customers that we expect to take the early-pay discount: 1.5%

Average days that it currently takes to collect on trade sales (receivables) and the customers that will likely take advantage of the early-pay discount: 45

Early-pay discount to be given if credit sale is paid within a certain number of days? 10%

Discount rate           =     8.5% + 1.5% = 10% or .10

Daily rate              =     Discount Rate =     .10 = .000274

365               365

Break-even discount     =     Daily Rate x Days Saved

=     .000274 x (45 – 10)

=     .000274 x 35

=     .009589

=     .96% or ~ 1%