What is a Cash Discount
A cash discount is an incentive that a seller offers to a buyer in return for paying a bill owed before the scheduled due date. The seller will usually reduce the amount that the buyer owes by a small percentage or a set dollar amount. If used properly, cash discounts improve the days-sales-outstanding aspect of a business's cash conversion cycle.
BREAKING DOWN Cash Discount
For example, a typical cash discount would be if the seller offered a 2% discount on an invoice due in 30 days if the buyer were to pay within the first 10 days of receiving the invoice. In this case, providing a small cash discount would benefit the seller as it would allow her to access the cash sooner. The sooner a seller receives the cash, the earlier she can put the money back into her business to purchase more supplies and/or grow the company in other ways.
Cash Discount and Cash Conversion Cycle
Cash discounts can come into play in a company’s cash conversion cycle (CCC). The full CCC calculation is as follows:
CCC = DIO + DSO - DPO
DIO = days inventory outstanding
DSO = days sales outstanding
DPO = days payable outstanding
The cash conversion cycle is the number of days it takes for a company to convert its resources into cash flows. It measures the amount of time each net input dollar is tied up in the production prior to becoming cash from sales to customers. The metric includes the amount of time needed to sell inventory, collect receivables, and how long the company’s bill payment window is before the company incurs penalties. The CCC is also a measure of the effectiveness of company management and the company’s overall health, based on how fast it can convert.
CCC can highlight a company’s liquidity risk by measuring how long a firm will be deprived of cash if it increases its resource investments – and can be particularly helpful for investors who wish to draw a comparison between close competitors. Combined with other fundamental ratios, such as the return on equity (ROE) and return on assets (ROA), the CCC helps to define a company’s viability.
If a company can receive a cash discount at any stage of its CCC, this can help make the company more effective and shorten the number of days it can take to convert.