Chapter 8 Managing Working Capital

3.5 Early settlement discounts
(Dec 10, Dec 12)

3.5.1

Key Points

(a) Early settlement discounts are given to encourage early payment by customers. The cost of the discount is balanced against the savings the company receives from having less capital tied up due to a lower receivables balance and a shorter average collection period. Discounts may also reduce the number of irrecoverable debts. (b) The benefit in interest cost saved should exceed the cost of the discounts allowed.

3.5.2 Advantages and disadvantages of offering early settlement discounts:

Advantages	Disadvantages
(a) Early payment reduces the receivables balance and hence the finance costs. (b) Potential to reduce the irrecoverable debts arising. (c) Offers a choice to customers of payment terms.	(a) Difficulty in setting the appropriate terms. (b) Uncertainty as to when cash receipts will be received, complicating cash budgeting. (c) Unlikely to reduce irrecoverable debts in practice. (d) Customers pay over normal terms but still take the cash discount.

3.5.3	Example 5
	A company offers its goods to customers on 30 days’ credit, subject to satisfactory trade references. It also offers a 2% discount if payment is made within ten days of the date of the invoice.