Early-payment discount: how to calculate and arbitrate

Quick answer. An early-payment discount is a price reduction granted to a customer who pays before the due date. Its real cost annualises: a discount of x% to gain n days is roughly x% times 360 divided by n. At 2% for 30 days, that is close to 24% per year. You arbitrate by comparing this rate to the cost of your cash.

A supplier offers you a 2% discount if you pay within eight days instead of thirty-eight. The gesture looks modest, almost trivial. Yet behind those two percentage points lies one of the highest financing rates you will meet in the day-to-day management of your business. Conversely, if you are the one granting the discount to your customers, you give up part of your margin in exchange for faster cash. In both cases, the right decision is not made on instinct: it is calculated.

In cash-piloting files, we regularly see directors granting discounts by commercial reflex, or refusing them out of caution, without ever converting the discount into an annual rate. That very calculation often changes the verdict. This article gives you the method, on the seller side and the buyer side, with a worked example and the related accounting entries.

A settlement discount is a price reduction granted to a customer in return for payment before the normal due date, or even in cash. It is a financial reduction: it rewards payment speed, not a purchase volume (which would be a commercial rebate) nor a quality defect (which would be an allowance).

It should not be confused with bank discounting, which refers to assigning trade bills to a bank to obtain liquidity early. The two terms look alike, but the mechanism is different. Here, we deal only with the discount granted between a supplier and a customer.

The discount terms, that is the rate applicable in case of early payment, must appear on the invoice and in the general terms and conditions of sale, in line with article L441-1 of the French Commercial Code. This is a mandatory mention, even when the rate is nil.

The key point is this: a discount of a few percent applies to a gain of only a few days. To compare this discount to a loan or an investment, you must bring it back to an annual basis.

The formula is simple. The approximate annualised cost of a discount is:

discount rate times (360 divided by the number of days gained)

Take the reference example: 2% discount to pay 30 days before the due date. The calculation gives 2% times 360 divided by 30, which is about 24% per year. In other words, the buyer who does not take this discount implicitly finances itself at 24% over the period, and the supplier who grants it bears that cost.

Here are a few illustrations. These figures are only examples: none of these rates is a market standard, and every negotiation remains specific.

The lesson is clear: the fewer the days gained for a given discount, the higher the annualised rate. A discount that looks light in absolute value becomes a substantial financing cost once brought back to a year.

Our reading#

The useful mental benchmark: 2% for 30 days, that is about 24% per year. This is well above the cost of a bank overdraft or a classic cash loan. It means that, for a buyer with liquidity, paying early to take a discount of this order is almost always profitable. And that, for a seller, granting such a discount is a costly cash decision, not to be taken lightly.

The same discount reads differently depending on whether you face it or offer it. The table below sums up both views.

On the buyer side, the rule is mechanical. If you have the cash and the annualised discount exceeds your financing cost, you have an interest in paying early: you gain more by taking the discount than by investing or keeping that amount. If, on the contrary, you had to draw on an overdraft more expensive than the annualised discount to pay early, the operation makes no sense.

On the seller side, the analysis is less arithmetic and more strategic. You weigh the cost of the discount against two gains: the cash collected immediately, and the reduction of default risk. With a fragile customer, speeding up collection is sometimes worth the discount. With a good payer already on time, the discount only eats into your margin without changing the payment date.

The underestimated risk#

The most frequent mistake on the seller side is not the calculation, it is generalisation. A discount granted to the entire customer base without conditions benefits first the customers who already paid on time. You are therefore paying for a behaviour you used to get for free. The discount is a targeting tool: it makes sense to smooth cash on a specific segment, much less as a universal rebate. To frame the issue within your overall piloting, you can first measure your cash conversion cycle before deciding on a discount policy.

Here is the procedure, identical whether you receive or offer the discount.

1. Note the discount and the days gained. Identify the rate offered and the number of payment days brought forward versus the normal due date.
2. Treat the discount as a period cost. A 2% discount for 30 days is the price of those 30 days of lead, not an annual cost.
3. Annualise. Apply the formula: discount times 360 divided by the days gained.
4. Compare to your financing cost. On the buyer side, set the annualised rate against your overdraft or available yield. On the seller side, against your real cash need.
5. Decide and document. On the buyer side, pay early if the annualised discount is above your cost. On the seller side, target customers and write the discount term on the invoice and in your terms of sale.

A trading company we support invoices on average 40,000 euros per month to a distributor, payment at 60 days. The director is considering granting a 2% discount for settlement within 30 days, that is 30 days earlier.

The annualised cost of this discount comes out at about 24% (2% times 360 over 30). In value, 2% on 40,000 euros represents 800 euros of discount per month, close to 9,600 euros over the year if every flow benefits. Against this, the cash advance obtained corresponds to one month of turnover collected earlier.

Our recommendation was not to generalise the discount, but to reserve it for an identified period of cash tension and for this specific customer, rather than setting it as standard for everyone. The calculation turned a gut-feel decision into an objective one. To anticipate this kind of tension, we build a 13-week cash plan upstream.

The entries are symmetrical between seller and buyer. For the seller, the discount granted is a financial expense recorded in account 665 "Discounts granted". For the buyer, the discount obtained is financial income recorded in account 765 "Discounts obtained". The discount therefore appears in the financial result, not in the commercial margin: a useful point to read correctly where the discount appears in the income statement.

On the VAT side, the settlement discount reduces the VAT taxable base. The tax is therefore computed on the net amount of the discount when it is acquired. In practice, the invoice states the discount terms and the VAT base is adjusted accordingly. This technical point justifies framing the treatment with your chartered accountancy firm in Paris 8th district to avoid VAT discrepancies.

This treatment falls within the accounting mission of the chartered accountant, a profession regulated by the ordinance of 19 September 1945. Beyond the entry, the real value lies in the discount policy: whom to grant it to, at what rate, over which period. This is where the financial piloting KPIs to track take on their full meaning, and where an outsourced CFO to frame your discount policy can make the difference.