Cash discounts are incentives offered to buyers that reduce the amount owed to the seller by either a fixed amount or a percentage of the total bill.If an invoice fx is due in 30 days, a seller could offer the buyer a cash discount of say 2% if the invoice is paid within the first 10 days of receipt.
This means that discounts are essentially treated as compensation to the seller for providing credit to the buyer.
Whichever recording method is used, anytime a cash discount is taken by a buyer, this will reduce the seller's sales revenue.
You're getting a 2-percent discount, but that saving is spread over just 20 days, the difference between the regular due date and the discount period.
Had the terms been 2/10, net 60, that same 2-percent discount would have been spread over 50 days (60 less 10) and the effective interest rate on an annual basis would be about 15%.
The cost of capital is a mix of what debt capital would cost (e.g., a bank loan) and the cost of equity capital (selling stock).
For many small businesses the cost of capital ranges between 15 and 20 percent.
Small cash discounts like this benefit the seller because they increase the chance that a buyer will pay quickly, thus providing the seller with cash faster.
Having cash sooner rather than later allows the seller to put the cash back into the business faster – a good motive for any company.
One of the biggest assumptions in the formula is that you take the discount at the last possible day and you normally would pay on the last day of the nondiscount period.