Early Payment Discount or High Interest Credit Cards?

Unraveling the Myth: The Hidden Costs of Settlement Discounts on Cash Flow

In the world of business, the perennial challenge of managing cash flow often prompts entrepreneurs to explore creative solutions. One question we often get asked when cash flow is tight is whether offering settlement discounts—also known as early payment or prompt payment discounts—is a viable strategy. 

The Illusion of Cost-Effective Financing:

At first glance, the idea of offering a settlement discount appears to be an ingenious way to encourage early payment and expedite cash flow. For instance, if your standard payment terms are 30 days End of Month (EOM), and you decide to provide a 2.5% discount for customers who pay within 7 days of the invoice date, it seems like a win-win situation. By receiving payment 38 days earlier than usual, the cost of the discount might seem negligible compared to the benefits.

However, let's break down the math:

Effective Interest Rate=Discount Percentage/Days Early × 365

In this scenario, a 2.5% discount for payment 38 days early translates to an eye-watering 24% effective interest rate. Suddenly, the seemingly advantageous strategy doesn't appear as cost-effective as anticipated.

The Unfortunate Truth: Late Payers vs. Timely Settlers

The pitfalls of settlement discounts don't end with their high effective interest rates. The unfortunate reality is that those who consistently pay late are unlikely to change their behavior even in the face of tempting discounts. On the other hand, the customers who are already prompt in their payments are the ones most likely to take advantage of the scheme. This asymmetry further diminishes the benefits of offering settlement discounts as a strategy to encourage timely payments.

The Silver Lining: Final Thoughts on Settlement Discounts

While settlement discounts might not be an ideal strategy for encouraging early payments, the story isn't entirely bleak. There's a flip side to this narrative: if you can negotiate settlement discounts with your suppliers, seize the opportunity with both hands. Acquiring discounts from suppliers can be a powerful tool to enhance your own margins, contributing positively to your bottom line.

In the quest to optimize cash flow, it's essential to critically evaluate the true costs and benefits of various strategies. Settlement discounts, though seemingly attractive on the surface, may prove to be a costly form of financing with limited effectiveness in prompting timely payments. As businesses navigate the complex landscape of financial decisions, it becomes crucial to explore alternative methods that offer better returns and sustainable cash flow management.