What is an Early Payment Discount? A Complete Guide

Early payment discounts are discounts businesses offer to encourage customers to pay their bills early. In this guide, we’ll explore the different types of early payment discounts, how they are calculated, and the advantages and disadvantages of implementing an early payment discount program. 

What is an Early Payment Discount?

Businesses offer an early payment discount on invoices to its customers when they make the payment before the deadline. This gives your customers an incentive to pay earlier than the agreed terms. 

Why would you want to give this discount, though, especially if you’re owed the amount anyway? 

Many businesses need help making ends meet when it comes to their finances. This is often because they have to pay for things like materials and labour before they receive payment from their customers. This can lead to cash flow problems when a business doesn’t have enough money to pay for the things it needs to stay in operation.

Businesses can improve their cash flow by offering a discount to customers who pay their bills early. These discounts are called prompt payment discounts or early payment discounts. The idea is that by offering a discount, the business can encourage customers to pay their bills sooner, which means the business gets paid sooner. This can help the business have more money to pay its bills and invest in growth.

An alternative is to take a loan, but loans can be expensive, and most businesses need help paying them back. In contrast, early payment discounts can be cheaper for a business to get the money it needs because it doesn’t have to pay as much interest.

Types of Early Payment Discounts 

There are two ways in which this works:

• Either you give this option to your customer. This puts them in control of when to pay. This is called a static discount and has several drawbacks. For one, it is your customers who decide when to pay you.
• Customers usually reach out to you for a discount via an online portal. It gives you the flexibility to decide how much discount to give. This is called dynamic discount. You can adjust the discount depending on the actual pay date – the sooner they make the payment, the higher the discount. This is called the sliding scale discount. 

Now, let’s see how these three types of discounts are calculated. 

Early Payment Discount Example and How is it Calculated

Regardless of the type of early payment, the discount is calculated in the same way. Let’s consider you own a fabric store and receive an invoice from your supplier for Rs.15,000 worth of fabric. In the invoice terms, you’ll see something similar to this:

2/10 – net 30

This means, “pay me in 10 days, and I’ll give you a net 2% discount. If not, the full payment is due 30 days from now.”

Now, let’s see how you can calculate the discounted price from this line:

1. The original invoice amount is Rs.15,000, and the discount rate is 2%. Let’s convert the discount % to decimal by dividing it by 100. It becomes 0.02. 
2. Subtract 0.02 from 1 and then multiply the result by the invoice amount. (1-0.02) * 15,000 = new discounted total = Rs.14,700.
3. If you make the payment within the next 10 days, you must pay Rs.14,700. If not, after 30 days, you’ll have to pay Rs.15,000. 

Early Payment Discount Formula 

Considering the calculation shown in the previous section, the formula for the new discounted total can be expressed as follows: 

New discount price = Original invoice amount * (1 - discount%)

An alternative way to arrive at this discount price is as follows: 

New discount price = original invoice amount - (original invoice amount * discount%)

Early Payment Discount Advantages and Disadvantages 

Early payment discount advantages for businesses: 

• Improved Cash Flow: One of the main benefits is improving the cash flow without taking a loan. An improved cash flow makes it easier to pay your bills on time and invest in growth. 
• Cost Effective: Plus, these are more cost-effective than loans can ever be. An early pay discount ranges between 1–2%, way lower compared to interest rates. Plus, during times of inflation, access to funding becomes limited. 
• Increased Sales: Offering discounts can also help you retain customers and increase your sales in the long term. 
• Improved Financial Metrics: An early payment discount can also give you more control over your financial metrics, such as cash ratio and days sales outstanding. The cash ratio measures your ability to pay your current liabilities using only its most liquid assets. Days sales outstanding tell analysts about the average number of days it takes for a company to collect payment. 

There are several potential disadvantages of offering early payment discounts:

• Reduced revenue: By offering a discount, a business is essentially giving up some of the revenue it would have earned if the customer had paid the full amount. It can be if the business is already on thin margins.
• Complexity: Implementing an early payment discount program can be complex, as it requires tracking customer payments and calculating discounts. This can be time-consuming and may require additional resources.
• Credit risk: Offering early payment discounts may also increase a business’s credit risk, as it may encourage customers to take on credit. This could lead to increased accounts receivable and potentially higher default rates.
• Administrative costs: Implementing and managing an early payment discount program can also involve additional administrative costs, such as the cost of sending invoices and tracking payments.

Overall, it’s important for businesses to carefully consider the potential advantages and disadvantages of offering early payment discounts before implementing such a program. It may be beneficial in some cases, but there may be better approaches for some businesses.

Early Payment Discount Terms and Conditions

It’s important for businesses to clearly communicate the terms and conditions of their early payment discount program to customers to avoid misunderstandings and ensure that the program is implemented smoothly. Some discount payment terms are as follows: 

• Eligibility: It specifies who is eligible for a discount depending on customers, such as customers who make timely payments.
• Discount Amount: You can specify how much discount you have to give; it may be a fixed amount or a percentage of the total bill.
• Discount Payment Terms: You can specify discount payment terms, such as the days after the invoice date when the payment should be made. 
• Exclusions: This is where you specify the types of products/services excluded from the discount.
• Termination: You can specify conditions under which the discount can be terminated, such as if the customer fails to pay within specified payment terms. 

Conclusion

Early payment discounts can be useful for businesses looking to improve their cash flow and avoid financial struggles. By offering a discount to customers who pay their bills early, businesses can encourage timely payment and receive payment sooner than they would otherwise. 

Some customers may resist taking advantage of early payment discounts because they prefer to hold on to their cash as long as possible. This can nullify the motives and advantages. 

Ultimately, the decision to offer early payment discounts should be based on carefully analysing a business’s financial needs and goals.

FAQs on early payment discount

How much is the early payment discount? 

These discounts generally range between 1–2%, and if the payment is not made within the days mentioned, they’ll be liable to pay the full amount in 30–60 days. 

Is an early payment discount worth it? 

Whether or not an early payment discount is worth it depends on various factors, such as the business’s financial situation, discount amount, and the potential benefits and costs of implementing the program. 

Does early repayment improve credit scores? 

An early repayment program may not directly affect your credit score. However, it may indirectly do so by helping you improve your cash flow and helping you avoid taking loans. 

Where do early payment discounts go on income statements? 

Early payment discounts typically go on the income statement as a reduction in revenue.

What does 2/10 net 30 mean?

It means pay in 10 days for a 2% discount; otherwise, you’ll have to pay the full amount within 30 days.