Page 401 - F1 Integrated Workbook STUDENT 2018
P. 401
Working capital management – receivables, payables, inventory
and cash
1.4 Early settlement discounts
Cash discounts are given to encourage early payment by customers. The cost of the
discount is balanced against the savings the entity receives from having less capital
tied up due to a lower receivables balance and a shorter average collection period.
Discounts may also reduce the number of irrecoverable debts.
The calculation of the annual cost can be expressed as a formula:
Annual cost of discount = (1 + (discount/amount left to pay)) no of periods –1
where no. of periods = 365 I 52 I 12
no. of days/weeks/months
earlier the money is received.
Notice that the annual cost calculation is always based on the amount left to pay, i.e.
the amount net of discount.
If the cost of offering the discount exceeds the rate of overdraft interest, then the
discount should not be offered.
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