Finance and Lending
What Are Early Payment Discounts? Here’s the Complete Guide
August 16, 2022 |
The C2FO Team
Small to mid-sized businesses are facing cash flow issues as invoice payment periods increase. Find out how early payment discounts work and when you should use them.
If you’re like most other businesses, you might have noticed that it’s taking longer to get paid by your customers. Factors like COVID-19 and rising inflation are causing large customers to extend payment terms, which could leave your small to mid-sized business unable to secure the working capital needed to operate and grow.
As a result, more and more companies are seeking out financing options — including lines of credit, receivables financing and financing solutions — to help them access cash while they wait for payment.
While it’s nice to have these options, the costs can be incredibly high — several online lenders charge as much as 65% annual percentage rate (APR). Fortunately, there’s a more cost-friendly option: early payment discounts.
What is an early payment discount?
An early payment discount gives your customers an incentive to pay you earlier than your agreed terms. There are two common ways this works:
You extend the option to your customers. This puts your customer in control of when to pay you early.
Your customers extend the option to you — usually through an online portal. This puts you in control of when to offer a discount and receive early payment.
How is an early payment discount calculated?
There are three types of early payment discounts — static discounts, sliding scale discounts and dynamic discounts. Here’s how they work.
A static discount is an addition to your invoices’ credit terms, which looks like this: 2/10, net 30. This translates to: “Pay me in under 10 days, and I’ll give you a 2% discount. Otherwise, the full balance is due within 30 days.” Companies usually offer discounts ranging from 1% to 2% with 30- to 60-day terms.
Static discounts give your customers more control over when to pay you early, which has several drawbacks. To start, this option is often less convenient and predictable for you. Customers may also take advantage of alternative credit terms and get discounts without actually paying early. This means that your accounting team will likely spend more time tracking payments to make sure customers are complying with the terms. Plus, you might find you need to raise your prices to offset the extra cost, which might make your prices less competitive.
With sliding scale discounts, the discount is adjusted based on the customer’s actual pay date — the sooner they pay, the bigger the discount. There is usually a bigger window for qualifying for a discount. With 2/10 net 30, for example, the customer would have to pay within 10 days. In a sliding scale framework, they could still claim a discount at the 13th or 16th day.
Your customers will typically define the discount they want in exchange for early payment, expressed as an annual percentage rate (APR). For example, if their desired APR is 12% and you want to be paid 30 days early, you would grant a 1% discount (12% APR / 360 days = 0.03% x 30 days = 1% discount). As time passes, that discount would decrease in value.
Sliding scale discounts have a few advantages over static discounts:
- Customers have an extended time window for early payment.
The discount rate adjusts based on how early the customer pays.
Dynamic discounts take sliding discounts one step further by using supply and demand to determine your cost. With dynamic discounting, your customers fund a cash pool and set a target rate of return for the allotted cash. For example:
E Corp (the customer) is looking for a 12% APR return on its cash.
Vendor A has an urgent need for cash and a typical borrowing cost of 18% APR. Vendor A offers 14% APR in exchange for receiving $100,000 (minus the discount) 30 days early.
Vendor B needs to improve cash flow but has a line of credit with an APR of 11%. Vendor B offers 10% APR in exchange for receiving $50,000 (minus the discount) 30 days early.
If Vendor A and Vendor B are the only participants in the market, both of their offers will be accepted because when combined their customer achieves a return that exceeds its 12% APR target (12.8% to be exact).
Dynamic discounts give you the flexibility to offer a discount rate that makes sense for your business rather than accepting a static rate set by your customer. Some early payment programs offer additional products that give you more control over your rates and discounts.
For example, you can set the rate you are willing to pay to receive early payment with C2FO’s Name Your Rate®. If you want to avoid the cost of discounts altogether, the C2FO CashFlow+™ Card, allows you to get early payment in full and receive 1% cash back on all purchases made with the card.
Early payment discounts: pros and cons
Improving cash flow without taking on debt is the main benefit of offering an early payment discount. By increasing your cash flow, you are better positioned to pay your bills on time, invest in growth opportunities and bridge cash gaps during key reporting periods like quarter-end.
But the benefits don’t end there. Early payment platforms and dynamic discounting unlock several other perks:
Early payment discounts are more cost-effective than other working capital financing solutions such as bank loans, lines of credit or factoring services.
During inflationary periods, higher interest rates mean that funding access is more limited. Early payment discounts are an effective alternative to increase your working capital.
Early payment helps mitigate longer customer payment terms, which are common as businesses navigate pandemic recovery and inflation.
An early payment program gives you more control over your cash flow and financial metrics such as days sales outstanding (DSO), free cash flow and your cash ratio.
If you’re using an early payment platform, discounts are easy and efficient to implement.
Offering discounts can help you retain customers and even increase your sales.
Leveraging early payments does not require a credit check like many other financing options, making it more accessible.
However, there are some disadvantages of early payment discounts. Offering discounts cuts into your profits (though the benefits of early payment are often still worth it if your business has tight margins). If you opt for static discounts, customers may also take advantage of static discount terms attached to an invoice, deducting the discount without actually paying early.
Because early payment discounts are optional for your customers, they’re not always a reliable way to boost cash flow. Additionally, early payment discounts might not suit your business if you already have a reliable cash flow or access to alternative funding options with lower costs.
When does it make sense to offer an early payment discount?
Here are some factors to consider when evaluating whether early payment discounts address your business needs and goals.
Is the cost of the discount less than your cost of borrowing? If you have a line of credit or another funding source, check your rates and fees before offering discounts. Once you know your borrowing rate, convert discounts to APR to compare. You can convert discounts using this formula:
For example, imagine that your terms are 2/10, net 60 and you want to receive payment 50 days early. This gives you about an 14% APR [(0.02 / 50) * 360 = 14.4%]. If this rate is lower than your other funding source, consider offering discounts.
Are you factoring your invoices? Early payment discounts are far more cost-effective than invoice factoring. However, using discounts instead of factoring is only possible if your customers already support an early payment program. Factoring agreements also tend to be confusing and written to keep you locked in. But as long as your customers offer early payment programs, you can use both — and you’ll likely save more money than using factoring alone.
What are your working capital goals? If your company has performance targets related to financial metrics, early payments can help you reach these goals. For example, early payment discounts can decrease your DSO — the average number of days that it takes you to collect revenue after the sales date.
The urgency of your cash flow situation can also influence when it makes sense to request an early payment discount. If you need working capital right now, find out if any of your customers use C2FO’s Early Payment platform so you can request early payment today.
This article originally published November 7, 2018 and was updated August 16, 2022.