What is an early payment discount?
An early payment discount is a form of trade finance, allowing buyers to pay a discounted amount to suppliers in exchange for settling invoices before their maturity date. Also known as a prompt payment discount or early settlement discount, it’s typically calculated as a percentage of the goods and services purchased.
Early payment discounts can vary depending on how early the invoice is paid, most often through a dynamic discounting mechanism. For suppliers, an early payment discount improves cash flow by speeding up customer payments, thereby reducing their days of outstanding sales. This can positively increase their working capital, providing access to the extra working capital needed to fulfill customer orders or grow the business.
For buyers, early payment discounts mean a lower cost of goods and are likely to represent an attractive, risk-free return on the company’s cash. Buyers can also strengthen their supplier relationships by taking advantage of early payment discounts.
Early payment discount example
A common early payment discount set-up is expressed as ‘2/10 net 30 days’. In this example, the invoice needs to be paid within 30 days but the buyer can secure a 2% discount on their purchase if they pay the invoice within 10 days. So for an invoice worth $1,000, the buyer can pay $1,000 at 30 days – or alternatively, they can pay $980 within 10 days, thereby achieving a 2% ($20) discount.
From the buyer’s point of view, this translates into an attractive return on cash. The cost of credit can be calculated by using the following formula:
- Discount %/(100 – discount %) x 360/(Full allowed payment days – discount days)
So for 2/10 net 30 terms, the cost of credit is calculated as follows:
- 2/(100-2) x 360/(30 – 10)
= 2/98 x 360/20
For the company purchasing goods, 2/10 net 30 days therefore represents a very attractive return on cash of 36.7% – but equally, the discount equates to a high cost of funding from the point of view of the supplier.
Harnessing early payment discounts with dynamic discounting
Traditionally, early payment discounts are initiated by the supplier, which will offer discounts to customers when invoicing for goods or services. However, this type of arrangement lacks both certainty and flexibility.
To return to the example of 2/10 net 30 terms, if the buyer pays the invoice within 11 days instead of within 10 days, they will not be able to access any discount at all. This can make it difficult for some buyers to take advantage of early payment discounts, particularly if manual processes are used to handle invoices. Nor does this approach give suppliers any certainty that their customers will take advantage of the early payment discount on offer.
However, buying companies can also harness early payment discounts in a more flexible way by putting a dynamic discounting program in place. With dynamic discounting, buyers can give their suppliers the opportunity to take early payments on their invoices in exchange for a discount. And unlike traditional early payment discounts, buyers can access a discount any time between the day when the invoice is approved and the agreed maturity date. The discount will vary throughout that period: the earlier the buyer pays the invoice, the greater the discount they will receive.
Dynamic discounting differs from supply chain finance (also known as reverse factoring). With supply chain finance, suppliers can also receive early payment, but the arrangement is financed by a bank or other finance provider.
Benefits of dynamic discounting
Early payment discounts achieved via dynamic discounting can benefit both buyers and suppliers: suppliers receive payment earlier, thereby boosting their working capital position, while buyers pay less for purchases than they otherwise would. The benefits of dynamic discounting include:
Benefits for suppliers
- Access cash whenever it’s needed, whether for one-off requirements or a steady flow of cash
- Forecast cash flows more accurately by having more certainty over the timing of payment
- Invest in R&D and business growth
- Achieve a lower cost of funding than with other financing options such as factoring
Benefits for buyers
- Achieve cost savings on goods and services
- Earn a risk-free return on surplus cash at a higher rate than with traditional investments
- Strengthen supplier relationships
- Reduce the risk of supply chain disruption
Different flavors of dynamic discounting solutions are available. Some may harness technology such as artificial intelligence (AI) and predictive analytics to maximize the results of a dynamic discounting program, for example by using big data and market information to set the optimum APR for individual suppliers. Some technology partners also enable companies to switch seamlessly between supply chain finance and dynamic discounting as the need arises.