28 Feb The benefits of implementing early payment discounts
Early payment discounts can be a proactive way of minimising late payment, increasing customer loyalty, maximising profits and improving supplier relationships. When used strategically they can strengthen the whole supply chain – suppliers can recoup cash faster to bolster their working capital, and buyers can use the savings to reinvest in growth. Here we take a look at how early payment discounts work for both supplier and customer businesses, and explain how you can work them into your financial strategy for maximum benefit.
How Early Payment Discounts Work
An early payment discount occurs when a supplier offers a percentage reduction on the total invoice value when it’s settled in advance of the payment deadline. For example, a 2% discount for invoices paid within 10 days. Early payment discounts can be offered or negotiated on an invoice-by invoice basis, or agreed as a condition of a contract between a supplier and customer.
Example of an Early Payment Discount
Suppose a business invoices a customer for £20,000. The normal payment terms are 30 days. In order to encourage prompt payment, the business offers selected customers a 2% discount if invoices are paid within 10 days (this is usually written as 2/10 net 30 days).
If a customer takes advantage of the early payment discount, they pay £19,600. If the invoice is paid 20 days early, then the 2% discount (£400) effectively becomes a cost (or interest) paid by the supplier business to allow them use of the settled amount for those extra 20 days.
The effective annual interest rate/cost calculation relies upon whether single or multiple discounts are given. Multiple discounts result in compounding interest and depend upon the rate of discount given and the difference between the normal credit term days and the discount days.
For example, when early payment discounts are run through a ‘cost of early payment discounts’ formula such as that conducted by financial experts Plan Projections, the cost of giving a 2% discount on a repeat basis over the year results in an effective APR of 44.6%. However, if offering a 1% discount for paying 15 days early, the interest rate falls to 27.7%.
Dynamic Discounting is method of prompt payment discounting that involves a third-party. It’s different to traditional early payment discounts in that it sets the discount rate directly to the date of payment. In other words, rather than setting static discount terms, the earlier the payment is made, the greater the discount.
Dynamic discounting lets buyers and their suppliers initiate prompt payment discounts on an invoice-by-invoice basis. Using a third-party platform provider, both parties view invoices through a web-based platform and select, request and approve invoices for early payment. Both buyers and suppliers can request early payment of approved invoices. The buyer settles the invoice through the platform, and the supplier receives payment, minus a discounting fee.
The Effects of Early Payment Discounts
Recent research by Marketinvoice found that almost two-thirds of invoices issued by SMEs over 2017 were paid late – a total of over £21 billion. Late or unpaid invoices also cost a supplier business in terms of debt interest, additional administrative costs, and wasted time chasing payment. Offering early payment discounts encourages your customers to pay on time and this has many benefits.
Firstly, your business is likely to move to the front of any payment queue. Cash will return to your business faster, and your cash conversion cycle will sharpen, providing extra liquidity. Secondly, you’re more likely to receive payment from financially struggling customers looking to cut costs. Thirdly, early payment discounts can reduce the risk of bad debt, as the longer a payment is outstanding, the greater the risk that it will never be repaid. Lastly, offering early payment discounts to your customers builds loyalty, as customers may see the discount as an incentive to choose your business over your competitors.
There are costs involved with offering prompt payment discounts, and it’s important you weigh these up when deciding if offering early payment discounts is right for your business.
For instance, going by the above static rate example, if your company’s profit margins are around 10% and you give your client a 2% early payment discount, then you will be giving up 20% of that profit – a significant percentage.
As a customer, there are significant benefits of negotiating and securing an early payment discount from your suppliers. The most obvious benefit is that of improved profit margins. If you secure an early payment discount from a supplier, then that money goes straight into your bottom line. For Pay4 customers this can sometimes even offset the cost of Pay4 supplier payments finance.
If your supplier reports payment data to a credit bureau such as Experian or Dun & Bradstreet, your on-time or early payments will also strengthen your payment profile and credit report. Contact your suppliers’ accounts receivable department to find out if they report payment data to credit bureaus.
Ensuring your suppliers receive a steady flow of capital also helps to mitigate supply chain risk. Your suppliers will be more likely to be able to replenish stocks from their own suppliers, so if you have a sudden demand, they will be in a better position to help.
Paying your suppliers early requires you to have cash in your business ready to meet invoices as they arrive. If your business is awaiting payment from its own customers, this can create gaps in cash flow.
The mismatch of cash flow priorities between suppliers and customers inhibits prompt payment of invoices and exacerbates the issue of late payment. This is where intelligent use of business lending can help.
You can either use Invoice Finance and release the capital from your customer invoices to then ensure prompt payment to your own suppliers, or you can use a structured revolving credit facility like Pay4 which allows you to pay your supplier and other creditor invoices immediately with up to 120 days credit.The early payment discounts that this facilitates allows you to more than offset the cash flow impact of opening the line of revolving credit.
Offering Early Payment Discounts
As a supplier, offering an early payment discount can be a good way to strengthen cash flow and customer relationships, by swiftly recouping outlaid capital and proposing competitive price points. However, it’s important you judge your discount correctly to minimise the overall impact on your bottom line while also encouraging your customers to settle promptly.
When considering what early payment discount to offer your customers, you should take into account the following:
- what is standard for your industry
- what discounts (if any) your competitors are offering
- whether the client in question has a history of prompt payment
- how much late payment will impact your own cash flow
- your profit margin on the customer order
Set terms based on a sound analysis of your profit margins, the importance of the customer and the market standard. Consider what additional advantages you could offer your customers too, for example, faster shipping or lower base prices.
Terms are generally offered on an invoice-by-invoice basis. This allows a customer to decide whether to take a discount on some invoices, but not others. Dynamic discounting can be a useful way to manage the administration. However, if you wish to incorporate a policy that requires the whole account to be paid within the discount period, be sure to communicate the policy in writing, stating that it will apply on all future invoices.
Negotiating Early Payment Discounts
When looking to negotiate prompt payment discounts with your suppliers, you firstly need to understand the current value of your cash to your supplier. How much will they lose when compared to selling on normal terms? What need or other use do they currently have for cash? How important a customer are you to them?
Then you need to assess the cost to your business of paying early, for example, the interest you would lose, or the opportunity cost of not having the cash available to put to use elsewhere. Incorporating a revolving credit facility like Pay4 into your cash flow strategy can help negate these costs. If your business has the working capital readily available to fulfil the cash flow priorities of its suppliers, it’ll be in a strong position when it comes to negotiating payment terms. This is where obtaining the right finance solution is vital.
Once you’ve decided that you wish to negotiate an early payment discount, inform your supplier that you have the cash available to deploy in such a way as to benefit both parties. If they’re seeking to reduce late payments within their business, and are looking to put the cash to use elsewhere, you’re likely to be successful. Alongside prompt payment, the promise of repeat business can often be used as an effective negotiation tool.
Furthermore, it may be possible to negotiate a better discount than the usual amount offered by the supplier. For example, if you can offer immediate payment because you’ve incorporated a revolving credit facility into your working capital strategy, you may be able to push for an extra 1% discount. This will go directly to your bottom line and enhance your profits.
Accounting for Early Payment Discounts
VAT Rules for Discounts
The rules for VAT on early payment discounts changed in 2015. Previously, businesses only needed to account for VAT on the reduced price regardless of whether the customer paid promptly or not. This meant that even if the customer didn’t pay promptly, they still benefited from a reduced VAT charge. Since 31 March 2015, businesses must account for VAT based on the amount actually paid by the customer.
Most of the large accounting software providers have functionality built in to enable you to account for early payment discounts quickly and easily. For example, Sage has explicit guidance on how to incorporate early payment discounts into your accounting processes, Freshbooks has made it easy to add discounts, allowing you to add them with a percentage-based discount to the entire invoice, or as a specific line item, and Xero is currently in the process of delivering additional functionality to accommodate them.
Choosing Early Payment Discounts to Support Your Business
For fast-growing businesses, late payments can open up potentially fatal cash flow gaps. This can weaken the entire supply chain. Offering early payment discounts can encourage customers to pay more promptly, helping you to speed up your cash conversion cycle.
On the other side of the coin, if you’re seeking improved supplier terms, prompt payment can be a great way of reducing costs and optimising profits through early payment discounts. As well as the potential reduction in invoice value, early payment can enhance your supplier relationships, and help mitigate supply chain risk. Using a finance solution such as Pay4’s revolving credit facility to pay your suppliers enables you to benefit from maximum discounts without exposing your business to the danger of cash flow gaps.