What is an early payment discount?
An early payment discount is one form of trade finance and a way for companies to obtain a discount on a supplier’s invoice in exchange for paying the supplier early. In other words, a company pays less than the full amount due while the supplier receives payment earlier than they would under standard payment terms. For example, with a term of 2% 10 Net 30, the buyer (or company purchasing goods/services from the supplier) may deduct 2% from the invoice price if they pay by day 10. An early payment discount is also commonly referred to as a cash discount or prompt payment discount.
I’m a supplier. What is the upside and downside of early payment discounts?
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. Suppliers also feel that they will be rewarded with more business if they participate in customers’ early payment discount programs.
But for critical suppliers in the direct material supply chain, early payment discounts aren’t the win/win they’re often portrayed to be and any increase in customer demand can easily be negated. Using the example outlined above, the buyer receives a 2% discount on an invoice if that invoice is paid on day 10 rather than day 30. Essentially, the supplier is paying 2% of the invoice value for accelerating payment by 20 days. That’s an annualized percentage rate (APR) of 36%. Very few direct material suppliers have financing costs anywhere near those exorbitant rates.
Suppliers that find early payment discounts an attractive form of working capital finance should analyze the impact these discounts could have on supply chain costs. Interest rates on early payment discount terms that translate into an APR of 15% or more, place a heavy financial burden on suppliers. No efficiency is gained by a supplier incurring what is essentially a very high interest rate to get paid early. Furthermore, early payment discounts are at the discretion of the buyer and buyers can opt not to participate. This impedes the supplier’s ability to forecast cash flow.
I’m a buyer. Are early payment discounts programs good for my business?
It depends. If a buyer’s primary objective is to reduce cost of goods sold, then early payment discounts can be helpful in achieving that objective. However, to make a meaningful impact on this metric, most buyers need to participate in several supplier early pay discount programs.
On the flipside, if the buyer’s primary objective is to improve its cash conversion cycle or average days payable outstanding, then early payment discounts can have a negative impact. Other trade finance solutions, such as supply chain finance, can be much more effective in achieving this objective.
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 receivables finance programs.
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 financing 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 discounted at the supplier’s credit cost – unless the supplier pledges or sells its entire portfolio of receivables and sets up a series of complex cash control measures that reduce risk to the lender but add substantial operational cost and complexity to the supplier.
For suppliers, these options provide the benefits of early payment and improved cash flow without the high costs associated with early payment discounts. These programs also improve cash flow for buyers and provide access to large sums of working capital. These funds can be used to make large-scale investments in initiatives that increase innovation and productivity, while also positively impacting metrics like cost of goods sold and days payable outstanding.