When finance and accounting professionals talk about improving cash flow - one of the tools they have in their accounts receivable toolbox has been to offer early payment discounts. The purpose of this article is to take a closer look at what’s better for your company’s bottom line - getting paid early or getting paid on time?
Getting paid early requires the incentives of early payment discounts. Getting paid on time requires leveraging the power of smart receivable collections management software to maximize your customers’ engagement in their invoice payment obligations to your company.
Early payment discounts
The most common early payment discounts “2/10 net 30”. This means that the payment is due in 30 days, but the payment is made within 10 days then the payee will get a 2% discount.
By example, let’s say you have an outstanding invoice from that customer for $10,000 to be paid within 30 days. But if your customer pays the invoice within 10 days, you are going to give a 2% discount on that $10,000 (equal to $200 in discount)
Since early payment discounts can also be described as an annual interest rate - what is the effective interest cost of borrowing your customer’s money for 20 days?
For and extra 20 days of cash, you are paying 2%. Therefore, for 360 days, you are paying 2%*(360/20) = 36% interest!
In other words, when you offer a “2/10 net 30” early payment discount - you are in fact paying a super premium interest rate of 36% annual interest for accelerated cash flow.
So let’s say your company is doing $20M in annual revenue and customers representing 25% of your revenue take advantage of your 2% early payment discount. Two percent of $5M is $100,000. This is an enormous amount of revenue being given away to accelerate your cash flow.
In addition to lost revenue, there are other drawbacks to offering early payment discounts.
- Can you absorb the 2% discount? This discount may not seem like much but if your business operates on thin margins, these small discounts can add up and cut even further into profit.
- Inconsistent and unpredictable customer election rates since your customers have the option of paying you early at their convenience.
- Receiving discounted payments without early payment - offering early payment discounts can lead to your company giving up discounts to customers that aren’t actually paying you within 10 days but claim the 2% discount on their invoice payment.
- Extra work by your accounting team to track compliance - with early payment discounts you’ll need to track payments very carefully to make sure they’re being honest. This might mean extra work for your accounting team.
Is there a better way?
Getting paid on time
Promoting on time invoice payments is far less complicated, requires less accounts receivable labor and is much less expensive.
Digital communication is transforming accounts receivable from a static "Pay Me or Pay Me Early" to part of an ongoing collaboration where the provider and recipient of goods and services are mutually engaged from the get-go.
Frequent and consistent communication during the collections cycle maximizes your customers' engagement in their invoice payment obligations to your company.
Smart communication workflows can remedy revenue leakage that can take the form of unnecessary overhead costs, toleration of late customer payments, weak recovery of faulty deductions, or write-off levels that have crept too high.
In addition, intelligent accounts receivable collections software provides the foundation to a sustainable collections process that deliver benefits such as stronger protections from fraud, better cash-flow predictability, and happier customer service reps and customers.
Engaging with your customers early on within the collections cycle helps to proactively uncover any potential invoice problems enabling your collections team to resolve them long before the invoice due date thus enabling your customers to pay their invoices on time.
Furthermore, using smart workflows, you can keep all the revenue stakeholders in your company from the C-Suite, Account Receivable and Sales informed and engaged in the invoice collections process.
So next time you consider using an early payment discount to accelerate cash flow keep in mind that there is a much more powerful, affordable, measurable and effective alternative - getting paid on time.