4 Reasons to Use Dynamic Discounting Instead of Your Business Line of Credit
13 December 2022 |
The C2FO Team
A business line of credit can offer a flexible financing solution when you’re short on cash. Here’s why dynamic discounting might be an even better option.
If you’re a small to mid-sized business owner, you’ve most likely needed additional cash at some point. For example, you could have short-term costs such as equipment replacements or inventory that you don’t have the funds to cover. If you run a seasonal business, excess cash is necessary to handle income fluctuations. Perhaps your business is growing and you need more working capital to make investments such as hiring new staff, launching a marketing campaign or opening a new location.
If you’re waiting 90 to 120 days or more for customer payments to clear accounts receivable, you probably need extra funds to keep your business afloat. Many enterprises have extended invoice payment terms to keep more cash on hand while navigating the financial impacts of COVID-19, supply chain disruptions and inflation.
Whatever your reason for needing more funds, you may have considered using a business line of credit. Often more flexible than a business loan, a business line of credit offers revolving funds when you need them.
However, many businesses are now taking advantage of dynamic discounting instead, which can increase working capital without the costs or restrictions associated with business lines of credit. What’s the difference between these two solutions and why choose dynamic discounting over a line of credit?
What is a business line of credit? What is dynamic discounting?
A business line of credit is a financing arrangement that functions similarly to a credit card. You draw funds from your line of credit, as needed, within the credit limit set by your lender. You pay interest only on the amount of cash you’ve borrowed, and the available funds replenish as soon as you repay them. This differs from a traditional business loan, which gives you a sum of money that you start paying back immediately through fixed monthly payments at a fixed interest rate.
Business lines of credit can be secured or unsecured. Secured lines of credit require you to offer your assets as collateral, which the lender can seize if you fail to make payments. Unsecured lines of credit do not require collateral but are harder to qualify for and have higher interest rates.
Dynamic discounting is a form of early payment, an arrangement in which you offer customers a discount in exchange for paying an invoice earlier than your agreed terms. Early payment is considered a win-win working capital strategy: Your customers reduce their balance while you receive a cash flow boost at the risk-free cost of a small discount.
Early payment is traditionally a static offering. Customers either receive a fixed discount if they pay within a set time period or pay the full amount at the invoice’s regular term. Dynamic discounting is a more flexible early payment approach. It allows customers to pay at any time before the invoice’s full term, adjusting the discount amount based on when they pay. The earlier the customer pays, the bigger the discount.
4 advantages of dynamic discounting over a business line of credit
1. CONTROL WHEN AND HOW CUSTOMERS PAY INVOICES
For a small to mid-sized business, securing a Fortune 500 customer can mean access to the revenue needed to stabilise and grow. However, sometimes large enterprises can extend payment terms, especially as economic uncertainties motivate large companies to generate free cash flow. This can deplete working capital enough to cripple your business.
One of the advantages of dynamic discounting is that it gives you more control over when and how your customers pay invoices. Dynamic discounting programmes such as C2FO’s allow you to set the terms of your discount offer, and many companies are willing to accept these terms in exchange for a reduction in their cost of goods sold. This strategy gives you more agency over your cash flow rather than being subject to 60-, 90- or 120-day terms. A business line of credit can help bridge cash gaps in these scenarios, but it doesn’t address the underlying issue of longer customer payment periods.
2. ACCESS WORKING CAPITAL WHEN YOU NEED IT
Sufficient working capital is required to meet unexpected and short-term business expenses. A business line of credit might seem like an ideal solution for short-term cash needs because its revolving nature means you have continuous access to funds whenever you need them.
There are two caveats to this. First, you only have access to funds up to the limit set by your lender. If you have a significant expense or have already used a significant portion of your credit line, a business line of credit might be unable to provide enough working capital for your needs. Secondly, it can take several months or years to qualify for a business line of credit, especially if you have a small to mid-sized business. In this case, a business line of credit can’t give you access to working capital when you need it most. On the other hand, a dynamic discounting strategy takes minimal time to set up and leverage for much quicker results. You can also register for these programmes even if your business is new and underqualified for other financing solutions.
For example, C2FO’s Early Payment programme is already supported by many large enterprises, some of which may be your customers. In this case, you can set up an account within minutes and request early payment on outstanding invoices immediately. Imagine that you don’t have enough cash to fund next week’s payroll. If one of your customers accepts an early payment request, you can access that cash, minus the discount, in as little as 24 to 48 hours — not to mention, you won’t be paying any interest to access that working capital.
3. AVOID INTEREST PAYMENTS AND STRICT TERMS
Perhaps the greatest drawbacks to a business line of credit are interest payments and qualifying terms. Interest rates on a business line of credit typically fluctuate and depend on your creditworthiness. Some businesses can secure a line of credit near the prime rate, but others may have to pay upward of 20%. Many lenders also charge setup fees, monthly fees, an annual renewal fee and agreement amendment fees.
Business lines of credit are also notoriously hard to qualify for and have demanding terms. To qualify, you typically need to provide your business operating time (often at least two years), comprehensive financial records, a healthy credit score, collateral, detailed business plans and proof of personal financial investments in your business. If approved, you might be required to make personal guarantees and routinely report changes, such as financial ratios or key personnel losses. Essentially, lenders want to know that you have the revenue and assets to pay back a credit line right away.
On the other hand, dynamic discounting is a debt-free way to increase your working capital because you are funding the discount. For many small to mid-sized businesses, giving customers dynamic discounts is often a more cost-effective working capital solution than paying interest and fees on a line of credit. If not, the slight cost savings of a business line of credit still might not be worth the time and resources required by the complex approval and reporting processes.
4. STAY FINANCIALLY SECURE AND INDEPENDENT
A business line of credit is meant to be used only when you need it. It’s not a long-term solution for maintaining sufficient working capital and growing your business. While dynamic discounting helps businesses address cash shortages, it has another benefit that not all other forms of financing can offer: It’s a reliable way to maintain cash flow over time, and build a more financially secure and independent business.
Most businesses need financing at some point to operate and grow, but dynamic discounting can minimise your reliance on third-party lenders. This has several advantages. For one, you will most likely feel less stressed about your business’s financial health and its ability to make debt payments on time. You can focus less on keeping your business afloat and more on long-term growth plans. When you’re ready to grow your business, a reliable cash flow will also help you provide the proof of financial health needed to qualify for loans.
The bottom line
Many businesses — as many as 82%, according to some estimates — fail due to cash flow problems. Lines of credit are often used by small to mid-sized businesses to bridge cash gaps, especially when their customers extend payment terms. If your business is in this position, you might also consider dynamic discounting, a flexible approach to offering invoice discounts in exchange for early payment.
Dynamic discounting gives you more control over your accounts receivable, helps kick-start your business’s financial independence and can avert the need to face the steep interest payments and restrictive terms associated with a business line of credit. Even if you have a competitive interest rate on your business line of credit, dynamic discounting could be preferable when the cost is comparable or your credit limit is not high enough.
Interested in dynamic discounting but want a deeper understanding of how it works? Check out our other blog post to learn more.