An early payment discount is one form of trade finance in which a buyer pays less than the full invoice amount due by paying the supplier earlier than the invoice maturity date. An early payment discount is also commonly referred to as a cash discount or prompt payment discount. There are two approaches to early payment discounting. The first is dynamic discounting, which is a program offered by the buyer that allows the supplier to choose whether to advance payment on their invoices. The second approach is when the supplier offers their customer (the buyer) a discount on an invoice in exchange for early payment. Both approaches are similar in that they provide a financial solution that adapts to a company’s changing cash flow needs, business climate, and supply chain demands.
In a dynamic discounting program, the supplier chooses if, when, and which invoices to advance payment on. The discount rate is a sliding-scale annual percentage rate (APR), meaning the discount taken varies based on the date of supplier payment.
The other approach, which is ideally suited for smaller suppliers not covered in traditional dynamic discounting programs, provides the buyer the option to pay an invoice early based on discount tiers defined by the supplier. For example, a supplier may offer two discount tiers based on when the buyer chooses to pay. The first tier may be a term of 2% 10 Net 30, meaning the buyer can deduct 2% from the invoice price if they pay by day 10. The second tier may be 1% 20 Net 30, meaning the buyer can deduct 1% from the invoice price if they pay by day 20. This gives the buyer the flexibility to choose which discount tier to select based on when they decide to pay their supplier.
What are the advantages of early payment discounts for suppliers?
The primary advantage of early payment discounts is that suppliers can get paid sooner, which accelerates cash flow. It also reduces the risk of nonpayment or late payment. For some non-investment-grade suppliers, an early payment discount is an attractive alternative to traditional financing methods like commercial-based lending. Participating in early payment discount programs also strengthens suppliers’ relationships with their customers, sometimes resulting in additional business down the road.
Are early payment discount programs advantageous for the buyer?
It depends on the buyer’s goal. If a buyer’s primary objective is to reduce cost of goods sold (COGS), then early payment discount programs can be helpful in achieving that objective. On the flipside, if the buyer’s primary objective is to improve its cash conversion cycle or average days payable outstanding (DPO), other trade finance solutions such as supply chain finance can be much more effective in achieving that goal.
Alternatives to early payment discount
For buyers and suppliers looking to increase cash flow and optimize working capital, there are alternative trade finance solutions such as supply chain finance or accounts receivable finance.
Supply chain finance, also known as supplier finance or reverse factoring, is a set of solutions that optimizes cash flow by allowing businesses to lengthen their payment terms to suppliers while providing the option for their suppliers to get paid early. Receivables sold under a supply chain finance program are nominally discounted at a rate tied to the credit cost of the buyer, which in most cases is better than the credit cost a supplier would pay to its own financing providers.
Accounts receivable finance allows companies to receive early payment on their outstanding invoices. A company using accounts receivable financing commits some, or all, of its outstanding invoices to a funder for early payment in return for a small fee. Receivables sold or pledged under an accounts receivables financing program are typically discounted at the supplier’s credit cost – unless the supplier pledges or sells its entire portfolio of receivables.
All of these programs improve cash flow and provide access to large sums of working capital for buyers and suppliers alike. These funds can be used to make large-scale investments in initiatives that increase innovation and productivity, while also positively impacting critical financial metrics.
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