Thursday, February 5, 2009

Prompt Payment Discounts -- Seductive and Expensive

In a discussion about cash flow and accounts receivable management in a recent Chief Executive Boards International meeting, the subject of prompt payment discounts came up. In fact, the idea of a prompt payment discount was suggested to a member who was trying to figure out how to accelerate payment of some accounts receivable.

You're probably familiar with prompt payment discounts. You might normally offer payment terms of "Net 30", which means that you expect the customer to pay you within 30 days of the invoice date (or the customer's receipt of the invoice -- interpretations vary). If you quoted the customer Net 30, he is in fact contractually obligated to pay you in 30 days. While few customers would expect you to do work you didn't quote, or expect to pay you less than the total amount you quoted, many are totally cavalier about this important (and legally binding) component of the quotation/purchasing process.

Prompt payment discounts offer "dual terms" of a discount for payment sooner, and the full invoice amount for payment later. Usually stated as something like "1% 10, Net 30", meaning if the customer pays within 10 days she can simply subtract 1% of the invoice, pay it short and keep the money. And you'll write off the 1% as a sales discount.

Now, this is a minefield -- fraught with interpretation and abuse. First, when does the 10-day clock start and stop? Does it start when the invoice is dated? Mailed? Received by the customer? Entered by the customer in accounts payable? And, then when does it stop (the last date the customer can legitimately take it)? The date on the check? The date of the postmark? The date you receive it? The date you book it as income? You get the picture. So, the 10-day compliance becomes somewhat in the eye of the beholder. AND many customers (especially big ones) will take the 1% discount and pay you in 45 days, anyway, and then dare you to come collect it.

The seductive part is that 1% seems like a small price to pay for getting your money sooner. And it many times just disappears as a discount from revenue, rather than showing up as a cost. This seduction was pointed out by a member who said, "That's really expensive financing." Explaining further, he converted the 1% discount into a cost of money (interest) equation. Let's say for simplicity's sake that the customer actually pays in 10 days a bill he would have otherwise paid in 40 days. So, you got your money 30 days sooner. What did that cost you? Well, if it was a $100 invoice and he took a $1 discount, that's 1% per month interest -- 12% APR to "borrow" that money from your customer for 30 days. Here's another way to look at the 12% calculation -- you send a $100 invoice every month, and every month he pays it in 10 days instead of 40. What you've gotten is actually the first $100 10 days sooner than you would have. Yes, you accelerated all the rest by 30 days, too, but how much bigger was your bank account for any given month than it otherwise would have been? Not $1200, but $100. So, what happened was you "borrowed" $100 from the customer for 30 days, renewing that loan 12 times, at a cost of $12 in discounts over the 12 months. 12%, right?

The alternative? There's nothing wrong with debt, particularly to fund working capital (AR being a big piece of most people's working capital). If, instead of borrowing the $100 from the customer, you'd have gone to your bank and borrowed it in the first month as part of a revolving line of credit, you'd probably have paid about 5% APR. Keep in mind that the customer was going to pay each of the bills every month anyway -- you just got the benefit of not having to fund the first month's delay, right? So, who would you rather borrow from a bank at 5% or a customer at 12%? More importantly, you can pay the bank back on any days when you have excess cash, and your cost of money is zero for those days.

Or look at it yet another way. Let's say EVERY customer took your 1% offer (after all, they're earning 12% interest by doing so, why wouldn't they? Let's also say your business is a "median" performer at, say, 8% pretax operating profit to sales. Except that you take a 1% haircut on operating profit because of all those discounts. What's 1% of 8%? 12.5%, right? So everyone in the company has to work 12.5% more hours, you have to buy 12.5% more material and get 12.5% more orders to support your prompt payment strategy. Whether you actually need the money or not -- you're stuck with living by the terms you offered. You could make a tiny improvement in your operation, become awash with cash, and still be working 12.5% harder because of your discount offer.

Now, all of this assumes your credit is good and your collateral is solid. If you can't get a bank to loan you money for working capital, you have worse problems than a prompt payment discount will solve.

You might do better with a late payment penalty. In this case, you have to invoice the customer for the late fee. And you have to aggressively pursue collection of the late fee. They're hard to collect, and you'll find yourself writing off some, but they do make the point -- you deserve and expect to be paid on time, and you'll take action if that's not the case.

If you have some favorite ways of accelerating cash flow by reducing Accounts Receivable, please click "Comments" below and share them with us.

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Terry Weaver

Chief Executive Boards International

Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it

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