Just about everyone who pays bills has felt the financial sting of late fees on occasion. And while businesses looking to maximize their cash flow might prefer to pay as late as possible while still avoiding those fees, there’s value to be captured from paying your suppliers well before the due date.
Early payment discounts can help you capture more value from the simple act of paying your bills. When vendors and buyers strike the right balance, it’s a win-win option that builds stronger business relationships and helps both parties manage their cash flow more effectively.
What are Early Payment Discounts?
Also called cash discounts or prompt payment discounts, early payment discounts are a method of trade finance wherein vendors offer their buyers a discount on outstanding invoices as an incentive to pay early.
This is ostensibly a win-win arrangement, securing cost savings for the buyer via accounts payable and more ready cash on hand for the supplier via accounts receivable.
Suppliers who offer early payment discounts to their buyers can set controls on when discounts trigger and the amount offered, leaving buyers to choose whether to capture savings or hold onto their cash a little longer.
“Paying invoices on time or in an early payment discount period helps establish and protect business credit. The better your credit, the more welcoming you will find new suppliers, investors, and lenders.”
How Early Payment Discounts are Calculated
Early payment discount terms can take a variety of forms depending on supplier preference and the credit terms and pricing negotiated.
Three of the most common options are static discounts, sliding scale discounts, and dynamic discounts.
A simple modification to negotiated credit terms. For example, if an invoice has the terms “2/10 – net 30”, it means the customer has 30 days to pay the full amount due, but can deduct 2% of the total amount if the vendor will receive payment within 10 days instead.
Consider this example: You receive a $10,000 invoice from a vendor and the terms are 2/15 – Net 30. You decide to pay within 15 days, and issue payment for $9,800 ($10,000 – (10,000 x .02) = $9,800).
Sliding Scale Discounts
This method doesn’t have a specific discount period, but ties discounting to the actual pay date. With sliding scale discounts, the customer pays an amount based on a fraction of the offered discount.
So for an invoice with 2/10 Net 30 pricing, a sliding scale might look something like this:
Pay on Day
The newest and most complicated approach, dynamic discounts take the concept of sliding scale discounts and ties them to supply and demand. Buyers set a cash pool with a targeted rate of return, and use it to determine their buying habits. The goal here is to provide reasonable flexibility that reflects the needs of the suppliers and current market conditions while providing attractive incentives to buyers with the working capital to take advantage of those incentives.
Let’s say your company is looking for a 12% return on cash spend.
Supplier ABC usually offers an APR of 19%, but is willing to offer a 15% interest rate for customers paying $75,000 or more on Net 30 terms.
Supplier XYZ offers its customers a line of credit with a 13% APR. They are willing to drop the APR to 12% for customers paying $50,000 or more on Net 30 terms.
The discount for Supplier ABC comes to $13,350.
Standard Payment Terms:
19% APR x $75,000 = $14,250
15% ÷ 360 days/fiscal year = .0004
.0004 x 30 days = 1.2%
1.2% x $75,000 = $900
$14,250 – 900 = $13,350
The discount for Supplier XYZ comes to $6,000
Standard Payment Terms:
13% APR x $50,000 = $6,500
12% ÷ 360 days/fiscal year = .0003
.0003 x 30 days = 1%
1% x $50,000 = $500
$6,500 – 500 = $6,000
The total discounts come to $19,350 ($13,350 + $6,0000 = $19,350).
Now, we compare the savings to the amount of cash spent:
$19,350 ÷ 125,000 = 15.5%
Since the target APR was 12% and the savings represent a return of 15.5%, your company would be wise to accept both of these offers.
Benefits of Early Payment Discounts
For buyers, the appeal of securing immediate cash savings can be very compelling, especially if they have sufficient cash on hand to pay the full invoice amount early without causing cash flow problems.
Paying invoices on time or in an early payment discount period helps establish and protect business credit. The better your credit, the more welcoming you will find new suppliers, investors, and lenders.
They’ll also build stronger relationships with their suppliers. This can open the door to even more favorable credit and payment terms in later negotiations, as well as opportunities to collaborate in mutually beneficial ways (e.g., product development, exploration of new materials, shared investment initiatives in technology, etc.).
For suppliers, customers who take advantage of the early payment discount terms can be a reliable source of cash that helps eliminate gaps in their working capital. Offering early payment discounts in tandem with electronic invoicing (eInvoicing) can also reduce invoicing costs. It minimizes the need to tighten inventories or seek alternate sources of funding such as invoice factoring that provide immediate cash but prove much more costly in the long run.
A Few Caveats to Keep in Mind Regarding Early Payment Discounts
Even the most tempting prompt payment discount can be more trouble than it’s worth if you find yourself short of working capital in securing it. Even one or two bounced checks, overdraft fees, or nonpayment of outstanding invoices can completely negate the savings you receive from paying early on others.
You can also damage your credit rating, your relationships with suppliers and lenders, and create a painful pinch on your future cash flow when suppliers tighten their terms or eliminate credit altogether in favor of demanding payment on receipt.
Having a clear picture of your available and future cash flow is an essential part of leveraging early payment discounts effectively.
Consequently, investing in a comprehensive procurement solution such as Planergy is a smart bet. A best-in-class solution will integrate seamlessly with your accounting software, and you’ll have complete visibility into your spend data and access to advanced analytics, reporting, and forecasting tools that will help you manage your cash flow much more effectively—and still capture those tempting discounts when the time is right.
Naturally, it’s critical to have a complete understanding of how the early payment discounts work for each of your suppliers so you can avoid late payments, missing discounts, and taking discounts that aren’t actually yours to take. You can protect yourself (and your supplier relationships) from miscommunications and misunderstandings by ensuring the terms of the early payment discount program you’re using are formalized in writing, and both parties have signed off on them. Be especially sure to clearly outline timelines (e.g., When does the payment clock begin—when the invoice is sent, or when it is received?).
Take Advantage of Early Payment Discounts for Savings and Value
From managing cash flow effectively to building a stronger bottom line, a cash discount from a supplier—or an early payment from a customer—can make a powerful difference. To realize the full value offered by early payment discounts, make sure you have a clear understanding of what’s on offer, have hammered out the details in writing with your suppliers, and are ready to strategically balance your cash flow needs against the potential savings to be gained. You’ll have the working capital you need for growth and innovation while still saving money and meeting your obligations, and build stronger relationships with your suppliers at the same time.
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