Early Settlement Discounts

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Offering early settlement discounts

There are four main reasons why a business may offer its customers discounts to pay early:

  1. If cash is received earlier, it will improve the supplier’s liquidity position, because it reduces the length of its cash operating cycle. 

    This will be particularly important if a seller is suffering from cashflow problems.

  2. If the cash from customers is received early, the cost of financing receivables is reduced. 

    For example, if the supplier has an overdraft agreement under which it borrows at a cost of 10% per annum, then provided that the cost of offering the discount is less than the cost of the overdraft, the supplier will be better off financially.

  3. When customers are deciding which payments to make to suppliers and which ones to delay, they are likely to pay those suppliers offering a discount for early payment first. 

    From the point of view of the supplier offering the discount, this means that the incidence of bad debts is likely to be reduced, since customers will choose to pay them first if they are short of cash.

  4. It is possible that offering a discount may provide an incentive to new customers, because the cost of the goods from a supplier offering a discount may now be less than those of a supplier not offering a discount, provided that the potentially new customer pays within the specified time limit.

Receivables aren’t cash. So they need funding.

Think of this being funded by an overdraft. Therefore, the overdraft rate x receivables is the cost.

In questions you will be asked to compare the current policy cost, to a new policy cost (offering early settlement discounts) to see which is cheaper

Let’s have a think about this:

  1. Early settlement will mean receivables will get smaller and so the cost less

  2. However the discount is a cost to the company too so needs to be taken into account

The steps are as follows:

  1. Step 1: Calculate current policy cost of receivables (receivables x Overdraft Interest rate)

  2. Step 2: Calculate NEW policy cost of NEW receivables (New receivables x overdraft interest rate)

  3. Step 3: Calculate cost of early settlement discount and add to the new policy cost

Illustration

Company has credit sales of 1200 and a 3 month credit policy.
New policy is 2% early settlement discount (within 10 days) and a new credit policy for others of 2 months
20% will take the discount. Cost of capital 10%

  1. Step 1: Old Policy cost of Receivables = 3/12 x 1200 = 300 x 10% = 30

  2. Step 2: New Policy cost of Receivables after = 2/12 x 80% x 1200 = 160 x 10% = 16
    + 10/365 x 20% x 1200 = 7 x 10% = 0.7

  3. Step 3: Cost of early settlement discount 2% x 20% x 1200 = 4.8

    Cost of Old Policy = 30
    Cost of New Policy = 16+0.7+4.8 = 21.5

    The cost of the new policy is less and so should be taken

Increase the credit term?

  • Occasionally you may be told that a new policy of INCREASING the credit term will also increase sales (as a larger credit term will attract more customers)

  • Remember here that the company is not better off by the full sales amount, but by the contribution (sales less variable costs) that these sales bring in.

    For example if extra sales are 100 and the contribution to sales ratio is 20%, then you will take an extra 20 income to the new policy calculation

  • You then need to compare this to the extra cost caused by the extra credit term (new receivables x overdraft rate)

Illustration

A company currently has sales of 1,200 and a credit term of 1 month.

It is planning to offer a term of 2 months in order to attract more customers. 

Their contribution to sales ratio is 20% and their overdraft rate is 10%. Sales are expected to increase by 20%

Is the change in policy a good idea?

  Current Policy New Policy
Cost of Receivables 1/12 x 1200 x 10% = 10 2/12 x 1,440 x 10% = 24
Extra Contribution   240 x 20% = (48)

The new policy has less costs than the current policy and so should be given the go-ahead

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