What it means
Sellers often give customers 30 or 60 days to pay. To speed up collection, a seller may offer a cash discount for paying within a shorter window.
The standard shorthand 2/10, net 30 means a 2% discount if paid within 10 days, with the full amount due within 30 days. For the seller, the discount is a cost of getting cash earlier.
It can reduce the need for borrowing and lower the risk of non-payment. Whether it is worthwhile depends on how expensive it is compared with the seller's cost of funds.
For the buyer, the discount can be a very attractive return on cash. Taking a 2% discount for paying 20 days early equals an annual return far higher than most bank interest.
Many finance teams therefore take early payment discounts whenever cash allows. Cash discounts are different from trade discounts and volume discounts.
A trade discount reduces the list price for certain customers, and a volume discount rewards bigger orders. A cash discount depends on payment timing alone.
In the accounts, the seller records discounts taken as a reduction in revenue or as a financing cost, depending on policy. The buyer records them as a reduction in purchases or as other income.
Companies should apply the policy consistently and make sure discounts are taken only when the payment is truly within the terms. There are risks to manage as well.
A buyer that takes the discount but pays late may be refused it later, and a seller that gives too many discounts may erode its margins. Clear terms on the invoice, and a consistent policy for handling late payers, help avoid arguments.
In practice
Real-world examples
Example 1
A wholesaler sells $20,000 of goods to a retailer on 2/10, net 30 terms. The retailer pays on day 8 and sends $19,600. It has saved $400 for paying 22 days early. For the wholesaler, the lower amount is a fair price for having cash three weeks sooner.
Example 2
A manufacturer is short of cash and offers a 3% discount for payment within 7 days on its $100,000 invoices. Half of its customers take the offer. The firm receives $48,500 per $50,000 invoice early and avoids a bank overdraft.
Example 3
A restaurant group declines a supplier's 1% discount because its cash is tight. The finance manager calculates that borrowing on its credit line costs less than the discount is worth. She decides to switch to taking the discount once the cash position improves. In the meantime, the supplier agrees to keep the offer open for another year.
Think of it
A cash discount is like getting $2 off your $100 grocery bill for paying with cash today instead of charging it.
Formula
Calculation
Annualised cost of forgoing the discount = Discount % / (100% - Discount %) x 365 / (Full credit days - Discount days)
Worked example: terms are 2/10, net 30 on a $50,000 invoice.
Step 1: Discount = $50,000 x 2% = $1,000, so the early payment is $49,000.
Step 2: Discount % / (100% - Discount %) = 2 / 98 = 0.0204.
Step 3: Days of extra credit given up = 30 - 10 = 20, so 365 / 20 = 18.25.
Step 4: Annualised cost = 0.0204 x 18.25 = 0.3724, or about 37.2%.
Missing the discount is like borrowing at about 37.2% a year, which is usually far more than a bank charges.Case study
Seen in the real world
Harborview Marine Supplies is an illustrative, fictional chandler that buys $600,000 of stock a year from a main supplier on 2/10, net 30 terms. For years, the accounts team paid on day 30. The new finance manager calculated the annualised cost of missing the discount at about 37%.
The company borrowed on a credit line at 9% to fund early payments. Taking the discount saved 2% of $600,000, or $12,000 a year, against extra interest of roughly $2,900 on the early payments. The net gain was about $9,100.
The illustrative lesson is that a small percentage can hide a large annual return. Comparing the discount with the cost of borrowing makes the decision clear. The supplier was happy, since it received its money earlier and its own borrowing fell, so both sides ended up better off.
Watch out
Common mistakes
- Ignoring early payment discounts because 2% looks small, when the annualised value is very large.
- Taking the discount but paying after the deadline, which breaches the terms and causes disputes.
- Confusing a cash discount with a trade discount or a volume discount.
Questions
People also ask
What does 2/10, net 30 mean?
It means a 2% discount if the invoice is paid within 10 days, otherwise the full amount is due within 30 days.
Should I always take a cash discount?
Usually yes if you have the cash or can borrow more cheaply than the annualised cost of the discount. If your cash is tight and borrowing is expensive, compare the two before deciding.
Does the seller lose money?
The seller gives up a small amount but receives cash earlier, which may save financing costs and reduce bad debt risk.
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