Cash Discount

What is a Cash Discount?

A cash discount, also called a purchase discount or sales discount, is a reduction in the purchase price of a good because of early cash payment. In other words, the seller of goods is willing to reduce the price of the goods if the buyer is willing to pay for the good earlier.

Cash discounts are incentives offered by sellers that reduce the amount that the buyer owes by either a percentage of the total bill or by a fixed amount.

For example, if an invoice is due in 30 days, a seller could offer the buyer a typical cash discount of 2% if they were to pay the invoice within the first 10 days of receiving it.

Small cash discounts benefit the seller because they increase the likelihood that a buyer will pay quickly. Cash discounts therefore provide the seller with cash faster; at times, it can be better to receive 95% of an invoice within a few days for example, rather than wait 30 or more days to receive the full amount.

Being paid early means that the seller can then reinvest the cash back into the business sooner.

Understanding the Cash Discount

There are two reasons why a seller might make this offer. First, the seller might need to obtain earlier use of cash, which may be necessary if the seller is short of it. Second, the seller might offer a discount or require an immediate cash payment in order to entirely avoid the effort of billing the customer. The latter situation arises when a seller does not want to expend resources to collect late payments from its customers.

Examples of a Cash Discount

Let’s assume that a company offers a cash discount and it is printed on its sales invoices as 1/10, net 30. Let’s also assume that a sales invoice is for $1,000 and the buyer has been authorized to return $100 of goods. Therefore, the net amount due to the seller within 30 days is $900. However, the buyer may deduct $9 (1% of $900) if the buyer pays the seller $891 within 10 days of the invoice date. The seller will usually record the $9 cash discount with a debit to the account Sales Discounts. The buyer will record the $9 savings as a credit to Purchase Discounts or as a reduction to the cost recorded in inventory.

My dentist offers a 5% cash discount if the dental fee is paid on the day of the service. This discount is offered to avoid the expenses of billing, mailing statements for unpaid amounts, processing partial payments, not collecting amounts owed, etc. The dentist and others accept credit card payments and pay a fee to a credit card processor in order to avoid similar expenses.

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.

How to Calculate a Cash Discount

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. The typical format in which cash discount terms are recorded on an invoice is as follows:

[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 in the following format:

2% 10 / Net 30

There are many variations on these cash discount terms, which tend to be standardized within industries.

How to Account for a Cash Discount

There are two different methods for recording cash discounts in your accounting journals: the gross method and the net method.

In the gross method, discounts that aren’t taken by the buyer (e.g. when the buyer does not pay within the discount period) are simply treated as a portion of total sales revenue. The gross method is most commonly used method in business practice today.

In the net method however, sales revenue is treated as the net amount after the given discount, and any discounts that the buyer doesn’t take are recorded as interest revenue. This means that discounts are essentially treated as compensation to the seller for providing credit to the buyer.

Whichever recording method is used, anytime a cash discount is taken by a buyer, this will reduce the seller’s sales revenue.

To record a payment from the buyer to the seller that involves a cash discount, debit the cash account for the amount paid, debit a sales discounts expense account for the amount of the discount, and credit the account receivable account for the full amount of the invoice being paid. For example, if the buyer is paying $980 on a $1,000 invoice, with the $20 difference being a cash discount for early payment, record a debit of $980 to the cash account, $20 to the sales discounts expense account, and a credit of $1,000 to the accounts receivable account.

When to Take a Cash Discount

A buyer accepts a cash discount if doing so carries an implied interest rate that is higher than the buyer would otherwise earn on normal investments, and if there is sufficient cash available to do so. A cash discount tends to be more favorable to the buyer than the seller, since the customary terms of cash discounts imply a very high interest rate. The formula for calculating this interest rate on a cash discount is:

Discount % ÷ (100-Discount %) x (360 ÷ (Full Allowed Payment Days – Discount Days))

For example, ABC International is offering a cash discount under 1% 10 / Net 30 terms, which means that it allows its buyers to take a 1% discount if they pay within 10 days; otherwise, ABC expects them to pay the full amount of the invoice in 30 days. The calculation of the implied interest rate to ABC in this deal is:

(1% ÷ 99%) x (360 ÷ (30 Normal payment days - 10 Discount days) = 18.2% interest rate

This is a fairly high interest rate, and on discount terms that are not especially high. Consequently, offering a cash discount is not always a good idea for the seller, unless it is severely short of cash. To make matters worse, some buyers pay late and still take the discount, so that the seller ends up offering an even higher implied interest rate. This can cause continual dickering between the parties, if the seller takes the position that the buyer did not take the discount under the terms offered on the invoice. The result may be disputed invoices that remain on the seller’s books for quite some time. This is also an added cost of doing business with a customer which should be considered when deciding whether the customer is sufficiently profitable.

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.

Advantages of the Cash Discount

  • It is an incentive given by the company to its customers in case they make the payment on or before the due date as per the company’s terms and conditions. To get the benefit of the discount, many customers pay right away to the company. So, it will save the time, efforts, and money of the company, which it might have to spend on the collection process for collecting the due amount from the customers on time.
  • When the customers pay on or before the due date, it results in faster access of cash flow to the company, which the company can use for other necessary activities like paying bills on time, getting the benefit of discounts given by their supplier by paying them on time, etc.
  • Due to cash discounts, many customers pay their dues on time. It reduces the company’s bad debts that in the future due to the non-payment of dues by the customers. Thus with such a discount, the company generally gets more amount of money when calculated for the overall business.

Disadvantages of the Cash Discount

  • The profit margin is reduced unnecessarily due to the cash discount given by the seller. In case of the business unit where there are satisfactory cash reserves, it only leads to fewer profits because the earlier recovery of cash is of no use and will not give any benefit to the seller but if the cash discount is not given then obviously the earnings of the business can be increased.
  • The policy of cash discounts will lead to time-consuming bookkeeping basics of accounts for the organizations as they are required to create cash discount allowances for which well-skilled staff is needed to be employed, and it involves a lot of time and estimations.
  • Sometimes the cash discount policy may lead to the loss of customers as many people can think that a small delay in discharging dues may result in the loss of discount to them. Now there is a possibility that they may get opposed that they are not given a discount, and they may prefer to walk out without making any purchase.
  • It will lead to a reduction in the sales value or turnover of the business. Turnover is the main criterion that is evaluated by the investor before investing in the business, and there are chances that less amount of turnover may stop an investor from investing their funds in that business.

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