Cash discounts look small on the invoice: 2% off if you pay ten days earlier. But two per cent for twenty days is not two per cent a year, it is the price of borrowing money for 20 days, and if you convert it into an annual rate it can be as high as 30% or more.
That is why the same discount can be an excellent deal for the buyer and a poor one for the seller, and why the choice depends on one comparison: the annual cost of the discount against the cost of the overdraft. This topic covers both sides.
It shows how to calculate the effective annual cost of an early settlement discount, how a seller decides whether to offer one to customers and how a buyer decides whether to accept one from a supplier, and how trade payables work as a free source of short-term finance and what happens when they are stretched. The next topic covers cash flow forecasts and the reasons for holding cash.
The topic completes the study of receivables and payables. In the working capital questions, discounts for cash settlement and longer supplier credit appear among the techniques recommended: in May Diet, 2026, Question 1(b), the memorandum listed discounts for cash settlement and negotiating extended terms with suppliers. Read debt factoring and invoice discounting first.
In 30 seconds
The annual cost of an early settlement discount = (1 + d ÷ (100 − d))365 ÷ t − 1, where d is the discount per cent and t is the number of days by which payment is accelerated (credit period less discount period). A seller should offer a discount only if its cost is below the cost of overdraft finance, or if the saving in the cost of financing receivables exceeds the cost of the discount actually given.
A buyer should accept a supplier’s discount if its annual value is higher than the cost of financing the early payment from the overdraft. Trade payables are a flexible, spontaneous source of finance with no explicit interest, but the credit period should not be exceeded and the cost of lost discounts should be considered.
The cost of an early settlement discount
A settlement discount is a reduction in price for paying earlier than the normal credit period. Paying d per cent less for money received t days sooner is a return, so the annual cost is:
Annual cost = [1 + d ÷ (100 − d)]365 ÷ t − 1
The amount left to pay is (100 − d), so the effective interest for the period is d ÷ (100 − d), compounded 365 ÷ t times in a year. T is the difference between the normal credit period and the discount period. For example, a discount of 2% for payment within 10 days instead of 40 days gives t = 30 and a rate for the period of 2 ÷ 98 = 2.04%. Annual cost = (1.0204)365 ÷ 30 − 1 = 27.9%.
Early settlement discounts to customers
The cost of financing receivables may be high. A company may give a discount to encourage customers to pay early, so that receivables, financing costs and perhaps bad debts fall. The discount should be offered only if its cost is lower than the interest rate on the overdraft. When only some customers take the discount, compare the saving in financing cost with the discount actually given.
Example: annual credit sales are ₦200m and customers pay after 60 days. The company proposes 2.5% for payment within 15 days. It expects 35% of customers (by value) to take it, and the overdraft costs 13%.
| ₦m | |
|---|---|
| Cost of the discount 35% × ₦200m × 2.5% | 1.75 |
| Current receivables 60 ÷ 365 × 200 | 32.88 |
| New receivables 15 ÷ 365 × 70 + 60 ÷ 365 × 130 | 24.25 |
| Fall in receivables | 8.63 |
| Saving in financing cost at 13% | 1.12 |
| Net benefit (saving less discount) | (0.63) |
The discount costs ₦1.75m and saves ₦1.12m of interest, so the company loses ₦0.63m and should not offer it. (Any saving in bad debts and administration would be added.) With a higher take-up, a lower discount or a higher overdraft rate the answer could change, so the sensitivity should be examined.
Early settlement discounts from suppliers
The value of a supplier’s discount is calculated in the same way. A buyer should accept the discount if its annual value is higher than the cost of financing the payment by overdraft, and decline it otherwise. For example, a supplier offers 1.5% for payment in 10 days instead of 30. t = 20 and the annual value is (1 + 1.5 ÷ 98.5)365 ÷ 20 − 1 = 31.8%. If the overdraft costs 14%, the buyer should borrow to pay early and take the discount.
Bulk purchase discounts are evaluated differently: the buyer compares the total cost of purchases, ordering and holding at each order size, as in the topic on inventory management.
Trade payables as a source of finance
Trade credit allows the buyer to use goods without paying at once. It is a common source of short-term finance, with no explicit interest charge, spontaneous, flexible and often needing no formal agreement. The company should use the credit terms offered, negotiate the best terms it can and treat the credit as free finance for working capital.
It must not exceed the agreed period or amount, because that can destroy the trading relationship and shut off the free source. It must also consider the penalties for late payment and the cost of discounts given up by paying late.
Example: a company buys ₦120m a year and extends payment from 30 to 45 days. The extra credit is 15 ÷ 365 × ₦120m = ₦4.93m and, at an overdraft rate of 14%, saves interest of ₦0.69m. But if paying late costs a 1% discount worth ₦1.2m a year (1% of ₦120m), stretching the payables costs more than it saves.
The ideas in more depth
Why the annual rate is so high
A small discount for a short advance is a large return, because the same short period can be repeated many times a year. A discount of 2.04% earned over 30 days, repeated 12 times, is far more than 2.04% a year. This is why a supplier’s discount is usually worth taking even when it means borrowing.
Why the seller and buyer may disagree
The buyer compares the annual value with its overdraft rate and may accept; the seller compares the discount given with the interest saved and may find it dear. Both can be right: the seller pays the discount on all customers who take it, including those who would have paid early anyway, while the buyer gets it on every invoice.
Sources and references
- No accounting standard governs the decision. Cash discounts are accounted for under International Financial Reporting Standard (IFRS) 15 Revenue from Contracts with Customers as part of the transaction price, and the supplier’s credit as part of trade payables.
These points are stated as at 5 November 2026.
Worked examples
Example 1: the annual cost. A discount of 2% for payment in 10 days instead of 40. Required: the annual cost.
- Period rate.
2 ÷ 98 = 2.04%
t = 30 days. - Annual.
(1.0204)365 ÷ 30 − 1 = 27.9%.
Example 2: a supplier’s discount. 1.5% for payment in 10 days instead of 30; the overdraft costs 14%. Required: the decision.
- Annual value.
(1 + 1.5 ÷ 98.5)365 ÷ 20 − 1 = 31.8%. - Decision. 31.8% exceeds 14%, so accept the discount.
Example 3: the seller. The discount costs ₦1.75m and saves ₦1.12m of interest. Required: the decision.
- Net.
₦1.12m − ₦1.75m = −₦0.63m: do not offer.
How to answer in the exam
- Identify the party (seller or buyer) and the right comparison.
- Calculate t correctly as the credit period less the discount period.
- For a partial take-up, compute the new receivables as a weighted average and cost the discount on the value taken up.
- State the decision in one sentence and the qualitative factors.
Common mistakes in the exam
- Using t as the discount period instead of the days gained.
- Treating the discount percentage as an annual rate.
- Applying the discount to all customers when only some take it up.
- Forgetting to compare with the overdraft rate.
- Stretching payables without counting lost discounts.
- Ignoring the effect on the supplier relationship.
Quick revision
- Annual cost = [1 + d ÷ (100 − d)]^(365 ÷ t) − 1.
- Buyer: accept if the annual value exceeds the overdraft rate.
- Seller: offer if the interest saved exceeds the discount given.
- Trade credit is free finance if terms are kept; late payment may cost discounts and goodwill.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. A seller should offer a settlement discount only if:
- Sales are falling
- The price is high
- Its cost is below the overdraft interest rate (or the saving exceeds the cost)
- Customers ask
Show the answer
C. Compare the cost with the saving.
Question 2. The annual cost of a discount is:
- d × 365
- [1 + d ÷ (100 − d)]^(365 ÷ t) − 1
- d ÷ 100
- t ÷ 365
Show the answer
B. Compounded over the year.
Question 3. Trade credit carries:
- No explicit interest charge
- A high explicit interest rate
- A bank guarantee
- Mandatory security
Show the answer
A. It is spontaneous, free finance if the terms are kept.
Question 4. A buyer should accept a supplier’s discount if:
- The price is lower
- The supplier is old
- It has cash
- Its annual value exceeds the cost of overdraft finance
Show the answer
D. Otherwise decline.
Question 5. In the formula, t is:
- The discount percentage
- The days by which payment is accelerated
- The number of customers
- The tax rate
Show the answer
B. The credit period less the discount period.
Question 6. A settlement discount to customers can:
- Reduce receivables and perhaps bad debts
- Increase receivables
- Remove all costs
- Raise the price
Show the answer
A. It speeds the collection of cash.
Question 7. The cost of a discount to the seller is:
- The cost of the overdraft
- Total sales
- The sales value taking the discount × the discount rate
- The tax
Show the answer
C. Only those who actually take it up.
Question 8. A company should not exceed its trade credit terms because:
- It is cheaper
- The supplier will lend more
- It is required by tax law
- It may destroy the relationship and shut off the free finance
Show the answer
D. Penalties and lost discounts also arise.
Question 9. The benefit of a customer discount is the:
- Higher price
- Lower sales
- Saving in the cost of financing receivables
- Higher inventory
Show the answer
C. It is compared with the discount cost.
Question 10. Extending the payables period normally:
- Shortens the cash operating cycle
- Lengthens it
- Has no effect
- Raises receivables
Show the answer
A. The supplier finances more of the cycle.
Section B style: written questions
Question 11 (10 marks). (a) State the formula for the annual cost of a settlement discount and define each term. (4 marks) (b) State the decision rule for a seller and a buyer. (4 marks) (c) State why trade credit is a useful source of finance. (2 marks)
Question 12 (15 marks). A supplier offers a discount of 1% for payment in 10 days instead of 60 days. The buyer’s overdraft costs 12%. (a) Calculate the period gained. (2 marks) (b) Calculate the annual value of the discount. (6 marks) (c) Advise the buyer. (4 marks) (d) State TWO risks of stretching payables instead. (3 marks)
A further written question
Question 13 (20 marks). A company with annual credit sales of ₦150m, whose customers pay after 50 days, offers 2% for payment within 10 days. It expects 40% of customers by value to accept, and its overdraft costs 15%. It also buys on credit and is offered 3% for payment in 10 days instead of 45 days.
(a) Calculate the cost of the customer discount. (3 marks) (b) Calculate the current and new receivables and the saving in finance cost. (8 marks) (c) State whether the customer discount should be offered. (3 marks) (d) Calculate the annual value of the supplier’s discount and advise. (6 marks)
Model answers
Show the model answer to Question 11
(a) Annual cost = [1 + d ÷ (100 − d)]^(365 ÷ t) − 1 (2); d is the discount per cent and t the days by which payment is accelerated (2).
(b) Seller: offer only if the discount costs less than the overdraft interest it saves (2). Buyer: accept if the annual value is above the cost of overdraft finance (2).
(c) It has no explicit interest, is flexible and arises spontaneously (2).
Show the model answer to Question 12
(a) 60 − 10 = 50 days (2).
(b)
- Period rate 1 ÷ 99 = 1.01% (2)
- annual value (1.0101)365 ÷ 50 − 1 = 7.6% (4).
(c) 7.6% is below the overdraft rate of 12%, so the buyer should not borrow to take the discount and should pay at day 60 (4).
(d) (1.5 each, any two) Loss of the supplier’s goodwill; penalties for late payment; loss of future credit.
Show the model answer to Question 13
(a) 40% × ₦150m × 2% = ₦1.2m (3).
(b)
- Current receivables 50 ÷ 365 × ₦150m = ₦20.55m (2).
- New receivables 10 ÷ 365 × ₦60m + 50 ÷ 365 × ₦90m = ₦1.64m + ₦12.33m = ₦13.97m (3).
- Fall ₦6.58m; saving at 15% = ₦0.99m (3).
(c) Net ₦0.99m − ₦1.2m = −₦0.21m, so the discount should not be offered (3).
(d)
- t = 35 days
- (1 + 3 ÷ 97)^(365 ÷ 35) − 1 = 37.4% (4), well above 15%, so accept and borrow to pay early (2).
Pathfinder on Early settlement discounts and trade payables
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The memorandum in part (b) (15 marks) recommends discounts for cash settlement or reduced credit terms for receivables, and negotiating extended credit terms with suppliers for payables.
Revise first: Early settlement discounts to customers
Source: ICAN Pathfinder, Financial Management. Diets covered: Every diet in the Pathfinder, November Diet, 2025 and May Diet, 2026, was reviewed here. The diets listed above test this topic directly..
Spotted a mistake? Tell us and we will check it.
