Finance and Lending
What are Early Payment Discounts? Here’s the Complete Guide.
November 3, 2020 |
The C2FO Team
Companies are waiting longer to get paid than at any point in the last decade.
In response, there has been an explosion in the number of financial institutions offering lines of credit, receivables financing, and factoring solutions to help businesses gain access to cash while they wait for payment.
It’s nice to have these options, but the costs can be incredibly high—several online lenders charge up to 99% APRs!
Fortunately, there’s a more cost friendly-option: early payment discounts.
What is an early payment discount?
An early payment discount is an incentive for customers to pay you earlier than your agreed-upon terms.
There are two common ways this works in practice:
- You extend the option to your customers
- Your customers extend the option to you—usually in the form of an online portal
When you extend an early payment option to your customers, it puts them in control of when to pay you early.
If your customer extends you an early payment option, it puts you in control of when to offer a discount and receive early payment.
How are early payment discounts calculated?
There are three types of early payment discounts:
- Static discounts
- Sliding scale discounts
- Dynamic discounts
A static discount is an addition to the credit terms on your invoices. That addition looks like this: 2/10, Net 30
In simple language, 2/10, Net 30 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.”
The discount companies offer usually ranges from one 1% to 2%, and the terms range from 30 to 60 days.
There are quite a few drawbacks of offering static discounts, including:
Inconsistent, unpredictable take rates
In a static discounting arrangement your clients have the option to pay you early at their convenience — which isn’t always convenient for you. It’s also far from predictable.
Receiving discounted payments without early payment
Offering discounts with alternative credit terms can lead to your company giving up discounts to customers that aren’t actually paying you any sooner.
Extra work by your accounting team to track compliance
If you give your customers an option to discount their invoices, you’ll need to track payments very carefully to make sure they’re being honest. This might mean extra work for your accounting team.
Sliding scale discounts
Sliding scale discounts are a modification of static discounting where the discount amount is adjusted based on the actual pay date.
With a sliding scale discount, your customer defines an APR amount they will accept to pay you early.
For example, if their desired APR is 12% and you want to be paid 30 days early, you would pay a 1% discount (12% APR / 360 days = .03% x 30 days = 1% discount).
The advantages of a sliding scale discount over a static discount are:
- You’re in control of when you get paid
- An extended time window for early payment
- An adjusted rate based on how many actual days you’re paid early
Dynamic discounts take sliding discounts one step further by using supply and demand to determine the price you pay.
With dynamic discounts, your customers fund a cash pool and set a target rate of return for the allotted cash.
It works like this:
- E Corp is looking for a 12% APR return on their cash.
- Vendor A has an urgent need for cash and a typical borrowing cost of 18% APR. They offer 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%. They offer 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% APR to be exact).
The most significant advantage of dynamic discounts is the flexibility to offer a discount rate that makes sense for your business rather than having to accept the static rate set by your customer.
What are the advantages of offering an early payment discount?
Improving cash flow without taking on debt has long been the main benefit of offering an early payment discount.
However, with the emergence of early payment platforms and dynamic discounting, the new ability to receive early payments on-demand unlocks several other benefits, including:
- The ability to control financial metrics like DSO
- Bridging cash gaps during key reporting periods like quarter-end
- More strategically managing working capital
What are the disadvantages of early payment discounts?
The most common arguments against offering a discount for early payment are:
- Tight margins (although there are several other advantages to accelerating invoice payments)
- Not needing to improve cash flow
- Alternative funding options with lower costs
When should you take advantage of early payment discounts?
Based on your needs and goals, there are several ways to evaluate whether or not to take advantage of a discount for early payment.
Is the cost of the discount less than your cost of borrowing?
If you have a line of credit or another source of funding, check your rates and fees before offering a discount.
Once you know your rate, make sure you convert any flat discounts to APR with this formula: ((discount rate / days-paid-early) * 360)
|2% / 10, Net 30||20 days paid early||(.02 / 20) * 360||36%|
|2% / 10, Net 60||50 days paid early||(.02 / 50) * 360||14%|
Are you factoring your invoices?
Offering a discount for early payment is a far cheaper way to improve your cash flow than factoring your invoices.
The challenges with using early payment discounts instead of factoring are:
- Using early payment discounts instead of factoring is only an option if you have access to an early payment program provided by your customer(s).
- Factoring agreements are often confusing and written to keep you in a factoring arrangement.
The good news is that if you have access to early payment programs from your customers, you can use early payments alongside your factoring arrangement — and likely save a bunch of money, too.
What are your working capital goals?
Does your company have performance goals related to financial metrics like days sales outstanding (DSO)?
Many larger companies take advantage of early payment discounts to decrease DSO—the average number of days that a company takes to collect revenue after the sales date.
Interested in early payment discounts for your business?
Search for a customer below to see if they offer an early payment program.