Finance and Lending
How Dynamic Discounting Compares to Other Funding Sources
November 8, 2022 |
The C2FO Team
Early payment discounts have been around for decades, but a newer twist on the concept — dynamic discounting — is an attractive alternative or complementary solution to traditional funding sources.
An early payment solution with dynamic discounting can help you accelerate customer payments and maintain a healthy supply of working capital — without paying soaring interest rates. Around the world, as central banks raise rates to fight inflation, more businesses are looking to shrink days sales outstanding (DSO) and improve their cash flow so they can avoid the high cost of borrowing, the Wall Street Journal reports.
Extended terms and delayed terms are a common problem for many companies.
In fact, a recent study showed that in the US, 39% of invoices are paid late and 52% of businesses have been asked by clients to extend their payment terms. This can cause businesses to experience periods of low or negative working capital and gaps in cash flow. For this and many other reasons, it’s not uncommon for businesses to seek out financing or otherwise look for ways to optimize net working capital.
What is dynamic discounting?
Dynamic discounting is a flexible and transparent early payment solution that gives you the option to view customers’ invoices online and request payment on demand in exchange for a discount. In the past, the only way to offer an early payment discount was to give your customer a static discount on the invoice for paying within a certain number of days.
Let’s take a closer look at how dynamic discounting compares to more traditional sources of funding to improve cash flow.
Dynamic discounting vs. static discounting
Static discounting, which has been around for many years, is steadily becoming outdated as rising costs put pressure on profit margins and businesses increase prices to offset the cost of discounts.
With static discounting, customers are typically given just two options: 100% payment at the full term of the invoice or a discounted amount before a fixed date. For example, terms of 2/10 net 30 mean that customers receive a 2% discount if they pay your invoice in full within the first 10 days of the invoice date. In other words, if they pay in fewer than 10 days, they get a 2% discount; otherwise, the full balance is due within 30 days.
In contrast, dynamic discounting offers your business many more benefits. With dynamic discounting, the timing and price of the discount are variable. This means you and your customers have the flexibility to agree on a discount for early payment at any time within the invoice terms. Your customers can choose to pay before the agreed term and get a discount that adjusts automatically based on the payment date.
Unlike static discounting, dynamic discounting offers you a longer window to accept early payments. Ultimately, it gives you more control over your cash flow than static discounting and minimizes one-off discount requests from your customers. Moreover, it reduces the need to increase prices to offset the cost of a fixed discount rate.
Dynamic discounting vs. invoice factoring
Invoice factoring is a type of financing that requires you to sell some or all of your company’s outstanding invoices to improve your working capital. Typically, when you factor an invoice, you sell it to a third party at a discount in exchange for the immediate payment of 70% to 90% of the invoice amount. Once the invoice is paid by your customer, the factor then pays you the remaining balance of your invoice minus its fees.
When you use invoice factoring, you can expect to pay a flat-rate invoice fee, generally 1% to 4%. Further, most invoice factoring companies charge additional fees based on the time between when they bought the invoice and when it was paid. These fees add up. It’s not uncommon to see APRs above 30%, which makes invoice factoring one of the most expensive ways to improve cash flow.
Factors usually advance a portion of outstanding invoices and pay you the remainder only after they get paid the full amount. In contrast, there is no advance rate with dynamic discounting. Rather than wait for the additional amount due, you can have your customer pay that invoice early, which will release your remaining funds and give you an immediate boost in cash flow.
Both factoring and dynamic discounting provide access to capital by discounting your invoices. However, with dynamic discounting you:
- Receive the full amount of your invoice upfront, minus the discount.
- Maintain full ownership of your invoices.
- Pay substantially less in fees.
It may make sense to use invoice factoring when not all of your invoices are available through a dynamic discounting or supply chain finance program and you do not have access to less expensive funding sources. But if you find yourself in this situation, you could opt to use C2FO’s Receivables Finance platform to finance any invoices that aren’t on the dynamic discounting platform.
Dynamic discounting vs. supply chain finance
Supply chain finance, also known as reverse factoring, is a way for buyers to provide liquidity to your business. It’s called reverse factoring because your buyer initiates the program with the bank or a third party, generally so the buyer can extend its payment terms. Financing is based on the strength of the buyer’s credit rather than your company’s creditworthiness.
One benefit of supply chain finance over traditional invoice factoring is that 100% of your customer-approved invoice value (minus fees) is available instead of just 70% to 90%. The rest of the mechanics remain the same. For example, the ownership of the invoice and payment remittance still shift to a third party. But the primary benefit of supply chain finance is the relatively low cost of financing.
Supply chain finance is often used when the buyer wants to offer early payment but needs to conserve cash. However, in most cases, supply chain finance programs are only available to a buyer’s biggest vendors.
In contrast, dynamic discounting offers a quick and easy approval process for early payment, doesn’t require the buyer to borrow funds, and you are able to maintain full ownership of your receivables. C2FO’s dynamic discounting and Dynamic Supplier FinanceTM, a version of supply chain finance, is available to suppliers of all sizes because the patented technology allows C2FO to make smaller accelerations of payment, at scale.
With Dynamic Discounting, the cost is based on open invoices with your customers, while factoring price is determined by the credit profile of the customer (debtor’s) portfolio. The factor is more concerned with the creditworthiness of the invoiced party than with that of the company from which it purchased the receivable.
Because banks require complex underwriting on every supplier who uses their program, only the largest Tier 1 suppliers — generally 20% or less of a supplier base — have access to this form of early payment.
In addition, the type of factoring you choose can have a significant impact on your balance sheet and your cash flow. Factoring providers generally offer two different solutions: non-recourse factoring and recourse factoring.
With recourse factoring, business owners take on the risk if their customer fails to pay the invoice on time. Few factors offer solutions that are truly non-recourse, which removes the receivable from your balance sheet and cash is added as an asset.
But there is one area that factoring has a slight edge: Some of your customers may not offer an early payment program, which means that some of your invoices may not be available to convert immediately into cash flow.
With factoring, however, you can advance funds on any factor-approved invoice, regardless of customer. Should you find yourself in this situation, there is also another easy alternative that is less expensive called C2FO Receivables Finance.
Dynamic discounting vs. a line of credit
A line of credit (LOC) is a form of financing that you can draw from on demand, and it works much like a credit card. A credit limit is set by your lender during the approval process. As you draw on the funds, the amount of credit available decreases. When you repay the line, your available credit increases, up to the maximum of your credit limit.
LOCs can provide a great deal of flexibility at a relatively low cost — but they can be challenging to qualify for and often require a personal guarantee. They also sometimes include restrictive terms, or rules, that you must comply with in order to keep the line open. Some even require you to communicate things like:
- Unforeseen events within the business that could impact long-term earnings.
- Changes in financial ratios related to cash flow and leverage.
- The loss of key personnel.
To secure a LOC with a traditional lender, your company must have a long business history and enough existing cash flow and assets to repay the line in a timely manner. The cost for a LOC is most often based on The Wall Street Journal prime rate plus 0% to 3%. The exact rate depends on the strength of your credit.
Like a LOC, you can use dynamic discounting to access cash on demand. The difference is that the amount of funds you have access to through dynamic discounting is determined by the value of your approved invoices rather than a preset limit from your bank. Unlike a line of credit, dynamic discounting is quick and easy to set up, and there are no strict rules, maintenance fees or balances to pay back.
At the prime rate, a LOC may appear to be cheaper than dynamic discounting, but this quickly changes when you add in the additional interest and fees. The simplicity of dynamic discounting is also an important thing to consider because the inconvenience of complying with the strict conditions may not be worth the cost saved.
Even if dynamic discounting has a similar cost to a LOC for your company, you can still use an early payment program in conjunction with a line of credit to increase available capital. We recommend using a dynamic discounting program instead of your LOC whenever it is less expensive or when you need additional capital beyond your credit limit.
Dynamic discounting vs. an asset-based loan
Asset-based lending refers to financing that is secured by collateral. Asset-based working capital loans (ABLs) are secured against receivables and sometimes inventory. They often require a personal guarantee and can come with extensive rules, many of which are even more oppressive than those that can come with a line of credit. With an ABL, your bank may require monthly, weekly or even daily reporting to ensure loan amounts do not exceed the value of the collateral. It is also important to note that most banks will advance only 80% of available collateral balances on asset-based loans.
Compared to a LOC, ABLs can be easier to get because they are secured by specific collateral, whereas most lines of credit are secured by general business assets. Unfortunately, while ABLs can be a less expensive form of financing, they aren’t as quick and easy to use as dynamic discounting or online factoring platforms. Also, setting up an ABL is not trivial. It requires complete access to all of your accounts receivable and inventory to fully document the collateral that the loan is secured against. With some banks, accessing capital from your ABL will require you to undergo a lengthy approval process prior to receiving any funds.
If you’re able to secure an ABL, it should be your least expensive source of funding outside of supply chain finance and some dynamic discounting scenarios. However, it’s favorable to leverage a dynamic discounting program when you don’t have time to wait for approvals or recertifications on an ABL. Otherwise, you could use a combination of the two if you need to increase your working capital.
When it comes to funding your business, the options we’ve presented above aren’t either/or. You can use a combination of these sources based on timing, cost, availability and impact on your company’s finances.
Many companies use dynamic discounting to decrease the fees charged by their factor by shortening the amount of time an invoice is outstanding. Others use dynamic discounting alongside a LOC to increase the amount of available capital. Large companies might use dynamic discounting in conjunction with factoring and an ABL to pull forward cash at quarter- and year-end from future-due invoices to their current balance sheets.
If your company has a finance manager, they will be able to help you choose the right options for your business.
This article originally published July 2020, and was updated November 2022.