Businesses that want to encourage prompt payment may offer a cash discount to buyers. A cash discount, also known as a sales discount or an early payment discount, is applied if the customer pays the balance within an allotted period. Cash discounts can improve business cash flow and reduce bad debts, but they might unnecessarily cut into the seller's profit margin.
Fewer Collection Efforts and Faster Cash Flow
In a perfect world, customers who purchase on credit would be paid up before or on their billing due date. Unfortunately, many businesses spend a large amount of time and resources haggling clients and tracking down payments. Offering a cash discount gives customers an incentive to pay right away, which means less time and money are spent in the collections process. Prompt payments also mean faster access to valuable cash flow, which makes it easier for the business to pay its own bills.
Avoid Bad Debts
Offering cash discounts may allow a business to retain more revenue and profit. Smart businesses vet out customers before they extend them large lines of credit. However, there's always a chance that a buyer will declare bankruptcy or simply skip town. Businesses often have no choice but to write off bad debt. A cash discount may mean the business only receives 99 or 98 percent of the face value of the sale price, but it may mean more money for the business overall.
Unnecessary Loss of Profit
A blanket cash discount policy may be offering responsible customers an unnecessary discount. If a business has customers who already pay on time and at full price, a sales discount may erode profit margin for no good reason. A cash discount might mean a customer pays a week or two earlier than normal, but this may not add much benefit to the business if it already has an adequate cash reserve.
Extra Accounting Legwork
Because it's hard to know how many customers will take advantage of a sales discount, generally accepted accounting principles require businesses with cash discounts to create an allowance for cash discounts. This contra-revenue account is updated regularly and lowers the value of net sales. If a business is trying to keep the value of sales high on the income statement, an allowance account may artificially deflate it. The allowance account also requires time and resources for accounting employees to maintain and can make basic receivable transactions more prone to error.