Trade discount: how to manage your cash flow

Late payments are a source of stress and budgetary imbalance, posing a real threat to a company’s long-term financial health. Trade discounting is therefore the ideal solution for encouraging customers to pay on time, thereby helping their supplier manage cash flow effectively. How does it work? Find out in this article!

Definition of trade discount

Derived from the Italian word “scontare”, meaning to deduct (or a deduction), a trade discount refers to a business offering a customer a reduction on condition that the customer pays within an agreed timeframe.

In a commercial context, a trade discount therefore links the supplier (providing goods and/or services) to certain customers of its choosing. It should not be confused with a bank discount, a process used in particular in the management of bills of exchange.

Although not compulsory, a trade discount is often a worthwhile strategy for both parties, encouraging the customer to pay as early as possible (or even in cash):

• the supplier benefits from better visibility and improved cash flow management;
• the customer benefits from a reduction that has a positive impact on their own cash flow.

Please note: it would be a mistake to confuse a trade discount with a rebate or a reduction, as the latter do not depend on any payment deadline. A reduction is instead based on order volume and applies only to the relevant line on the invoice, not to its total amount.

Setting a trade discount

Calculation

The rate applied under a trade discount is calculated on the total amount excluding tax to be invoiced. The applicable Value Added Tax (VAT) rate is then applied to this amount.

Good to know: as a reminder, you can find all VAT rates and the conditions for applying them in our article on the basis, rates and exemptions for Swiss VAT in 2021.

The formula to use is therefore:

Trade discount = (total amount excluding VAT × discount rate) × (1 + VAT)

Example calculation:

1. Goods are invoiced at CHF 500 (excl. VAT) at the reduced VAT rate (2.5%).
2. A trade discount of 10% is offered, subject to payment in cash.
3. The customer pays in cash and thereby qualifies for the trade discount.
4. The total trade discount is calculated as follows:

trade discount = (500 × 10%) × (1 + 2.5%) = 50 × 102.5% = CHF 51.25.
Please note: depending on whether you are the supplier or the customer, the resulting amount will be recorded under a different heading in your accounts.

Decision criteria

Although a trade discount allows the supplier to build loyalty and retain part of its customer base while improving its cash flow management, every sale granted at a discount involves a loss of income that may, over the long term, weigh on the company’s profitability.

Deciding whether or not to use this solution therefore requires, beforehand, estimating the amount offered over the year and comparing it with the losses caused by a certain percentage of unpaid invoices over the same period. Analysing the cash flow statement is therefore essential for this decision.

Good to know: a supplier can set several discount rates for the same service, decreasing in stages depending on how long the customer takes to pay. Payment terms are set freely by the company.

Your industry as well as your customer’s intentions regarding a potential trade discount are also good indicators. So don’t hesitate to start a conversation with your customers to find out whether such a solution would be worthwhile.

If you opt for a trade discount, bear in mind that the discount rate, once set, will likely remain stable: any increase would put the company at a disadvantage, while any decrease would upset the customer.

Adopting a trade discount necessarily means it must be stated clearly and legibly on the invoice, for example in the form:

“[…] trade discount of X% granted subject to payment before XX/XX/XXXX”.

Good to know: in the Swiss invoicing process, Swiss customers generally settle payment within 10 to 30 days. A trade discount would therefore be more worthwhile for rewarding payments made within a shorter timeframe.

Benefits of trade discount

While the benefit of a trade discount seems obvious for the customer, who benefits from a reduction on their order, the benefits are just as significant for the supplier:

• the company avoids numerous unpaid invoices and thereby keeps its customers motivated;
• the company has more cash available to manage its cash flow;
• the company builds loyalty among its most important business relationships.

However, even though a trade discount may seem like an opportunity worth taking for the customer, the customer remains free to meet the agreed payment deadlines or not. This factor must therefore still be taken into account by the supplier!

Despite this, the savings generated by this solution can be so significant for the customer that it sometimes becomes worthwhile to take out a bank loan in order to make payments more easily. The idea, then, is to compare the bank’s interest rate with the discount rate and the frequency of orders over the year.

A trade discount therefore represents a compromise from which both parties emerge as winners, provided the supplier and customer show goodwill. This solution is also relevant to international invoicing.