When to offer early payment discounts

Only a company having severe cash flow problems should offer early payment discounts to its customers. The problem is that the effective interest rate the company is offering to its customers is extremely high. For example, allowing customers to take a two percent discount if they pay in 10 days, versus the usual 30, means that the company is offering a two percent discount in order to obtain cash 20 days earlier than normal. The annualized interest rate of two percent for twenty days equates to an annualized rate of about 36 percent!

Furthermore, many customers will not pay within the 10-day discount period, but will still take the discount. This can lead to a great deal of difficulty in obtaining payment of the withheld discount.