To encourage customers to settle their invoices early and improve cash flow, many business owners offer an incentive. Payment terms such as “5% 10 net 30” mean a client can receive a 5% discount if their invoice is paid within 10 days; otherwise, they must pay the full amount within 30 days.
This tactic can motivate clients to pay sooner, rather than later. However, if too many clients take advantage of these discounts, your business may find itself with a much thinner profit margin. Here’s how to decide whether to give discounts to your customers if they remit payment ahead of schedule.
Do your competitors offer early payment discounts?
If no one else in your industry is offering an early payment discount, you may be able to gain an edge over your competitors. Find out if others in your industry offer early payment discounts (and if they do, how much). Customers may be willing to switch to your business if they see that you offer more favorable payment terms.
[Read more: Guide to Negotiating Payment Terms With Your Vendors]
Will early payments benefit your cash flow?
Many small businesses encounter cash flow issues at some point: in fact, one-third of merchants report that delays in receiving payments put their businesses at risk of closure. If your business is encountering cash flow problems, then offering early payment discounts can help increase incoming cash and help you pay your bills on time.
[Read more: Accounts Receivable: How to Improve Your Chances of Getting Paid]
How will an early payment discount impact your profit margin?
When customers regularly take advantage of early payment discounts, it can start to cut into your operating margin. Even small discounts can start to impact your profit. If you determine that offering a payment discount is necessary to remain competitive, consider pricing your product or service to account for future early payment discounts.
If no one else in your industry is offering an early payment discount, you may be able to gain an edge over your competitors.
Can an early discount increase customer retention?
Customer retention is the holy grail of long-term business growth. Research has shown that increasing customer retention rates by 5% will increase profits by 25% to 95%. A small discount for early payment may be all it takes to build loyalty among your clients.
“Even a small discount can help customers feel appreciated,” wrote The Fool. “While a 2% discount may not seem like much on a small order, the discount can quickly add up. In addition, customers receiving a discount may want to take advantage of it by upping their orders.”
Is your accounting team prepared to manage early payments?
Not all small businesses have a full-fledged accounting team in place to track and manage early payment discounts. If you are using a spreadsheet or manual accounting system to record your accounts payable and receivable, offering an early payment discount can quickly become a headache. Assess whether the extra work spent recording and tracking these incentives is worth the hassle.
Are the returns worth it?
Canada’s BDC Bank offers some simple, back-of-envelope calculations to help assess whether an early payment discount is financially savvy.
In their calculation, your business offers a 2% discount for customers that pay an invoice in 10 days. Otherwise, the full amount is due in 30 days (2% 10 net 30). Essentially, your business is gaining the use of money for 20 days in exchange for 2% off. A 2% return over 20 days is a 37% return when annualized.
“Your own return on investment or financing cost would have to be above 37% for it to make sense to offer a 2% 10 net 30 discount on an invoice. It would have to be above 18% for it to make sense to offer a 1% 10 net 30 discount,” wrote BDC.
Unless your business is experiencing cash flow issues, BDC experts say offering this early payment discount probably isn’t worth it. “If your customer is paying you within 30 days, it most likely doesn’t make sense from a financial point of view,” wrote BDC Business Consultant Jorge Henao. “As well, if you decide to stop giving the discounts, it might encourage your customers to start paying late.”
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