CASH DISCOUNT - Working Capital Management

A company short of cash resources and facing liquidity problem may consider the use of cash discounts to influence its customers to pay promptly. There are two important cash discount policy aspects:

  • cash discount rate.
  • discount period.

Giving the cash discount facility is not the same as cutting the prices and thereby affecting demand. It is a mechanism through which the company is giving some benefits to customers who opt to pay early. There is a remote possibility that all customers will pay the company their dues within the cash discount period. Only a segment of customers who have sufficient cash resource and good liquidity position will avail cash discount facility. The introduction of cash discount as a policy will also affect customers who were paying promptly earlier. Suppose 5 percent of sales were on cash basis and rest 95 percent on credit. By introducing cash discounts, the company has to pay cash discount to the 5 percent customers who were paying cash immediately at the time of sale. Some of the customers from the 95 percent segment would avail cash discount but certainly not all. The cash discount policy would result into loss of revenue to the company. At the same time the company would experience a quick collections resulting into lower collection period. The reduction in average collection period in turn will affect the investment in accounts receivable. Before deciding about the cash discount policy, the company has to find out whether the returns on funds released on account of reduction in investment in accounts receivable is more than the loss of revenue. Only if the returns completely offset the loss of revenue, the cash discount policy should be introduced. Let us once again take the example of ADE LIMITED example.

ADE LIMITED is contemplating to introduce a cash discount policy on the terms “2/10 net 30”. The terms imply that if the customer pays his bills within 10 days he gets a cash discount of 2 percent, otherwise the customer is required to clear his bills before 30th day. ADE LIMITED is expecting that 60 percent of sales will opt for cash discount and as a result the average collection period will improve from 30 days to 18 days.

Loss of revenue (8,000,000 x 0.6 x 0.02) = N96,000
Release of accounts receivable investments.

Accounts receivables before cash discount:
30 x (8,000,000/360) = N666,667

Accounts receivables after cash discount:
18 x (800,000/360) = N400,000
release on investment = N266,667
return on funds released = N266,667 x 0.15 = N400,000

Loss of revenue is more than the return on the amount of funds released and hence the cash discount policy should not be introduced.

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