What is an Early Payment Discount & How Is It Calculated?

On average, U.S. public companies are withholding payments 56.7 days longer than at any point in the past decade. The intent of delaying payment is to unlock cash, but could you be tripping yourself up from saving more?

A business can easily save money by slightly adjusting the timeline of something they already do: pay vendors. 

Everyone knows there can be penalties for paying a bill late. Contrarily, there can also be rewards for making payments early. Especially when it comes to vendor relationships and business transactions. 

What are Early Payment Discounts?

An early payment discount is a form of trade finance and a means for companies to obtain a discount on vendor invoices when paying early. A business pays less than the full amount due while the supplier receives payment earlier than standard payment terms. It benefits both accounts receivable and accounts payable and helps add to your bottom line.

It’s also an incentive for customers to pay you earlier than agreed upon. The two ways early payment discounts work are:

1. You extend the opportunity to customers.
2. Your vendors extend the option to you (typically in the form of an online portal).

When you extend this opportunity to customers, it puts them in control of when to pay early. If they extend it to you, it puts your business in control of when to offer a discount and receive payment.

How are Early Payment Discounts Calculated?

As a vendor, you define how many days early a discount can be applied and the amount. For example, an invoice with the terms 2/10 – net 30 means a net 30-day invoice with a 2% discount if paid in 10 days (instead of 30).

Static Discounts

This is an addition to credit terms on your invoices. Like the example above, a static discount offer usually ranges from 1-2% and the terms range from 30-60 days. There are a few drawbacks to offering a static discount that includes:

• Receiving discounts without early payment. Some customers take their own discount without paying on time.
• Unpredictable take rates. Since clients have the option to pay you early at their convenience, it’s not always a predictable process.
• Extra work for accounting. You need to track payments carefully when customers have the option to take their own discounts. This also means more work for the AP and AR teams. 

Sliding Scale Discounts

Sliding scale discounts happen when the amount is adjusted based on the actual pay date. The customer defines the APR amount they will accept to pay early. For example, if the APR is 12% and you want to be paid in 30 days, a 1% discount would suffice. It is calculated as such:

• 12% APR / 360 days = .03 x 30 days = 1% discount

There are many advantages to using this method of an early payment discount. These include:

1. Control when you get paid
2. Adjusted rate based on actual days
3. Extended time window for early payment

Dynamic Discounts

Dynamic discounting takes sliding discounts a step further. It uses supply and demand to determine the price. Customers fund a cash pool and set a target rate of return for the allotted cash. 

Here is how it works:

1. Your business is looking for a 12% APR return on cash.
2. Vendor A has an urgent need for cash and a typical APR of 18%. They offer 14% in exchange for receiving 100K on a net 30.
3. Vendor B has a line of credit with an 11% APR. They offer 10% APR in exchange for receiving $50k on a net 30.
4. If these two vendors are the only ones in the market, you should accept both offers because the combined offers achieve a discount rate that exceeds 12% APR. It’s 12.8% to be exact.

The idea behind dynamic discounts is the flexibility to offer a discount rate that makes sense for your business rather than accepting a static rate from customers.

The Benefits of Early Payment Discounts

There is a multitude of advantages to early payment discounts. 

As a Customer

Always paying invoices on time or early will help establish a customer’s business credit. This leads to improved terms when working with new and existing merchants. 

The primary benefit is saving money. If a customer pays within 10 days on a 2/10 term, the early payment discount is $20. The invoice drops to $980. This means if the customer is invoiced monthly, they save an average of $240 over the year.

As a Vendor

As borrowing costs rise, more companies are looking to access funds trapped in operations. They are negotiating longer payment terms, prompting customers to pay sooner, and shrink inventories to conserve working capital.

With the emergence of dynamic discounts and early payment platforms, the new ability to receive early payments on-demand unlocks other advantages like:

• Bridging cash gaps during key reporting periods like quarter-end.
• The ability to control financial metrics like DSO.
• More strategically managed working capital.

With net 60-90 terms, cash flow can be crimped. This means your business still has to pay for employees, expenses, and overhead. Operating expenses dwindle cash down the longer you wait to get paid. Thus, early pay discounts are a means to improve profit margins and help a small business float cash.

Getting your customers to agree to a discount period of 2/10 or 1/10 terms helps replenish cash flow and keeps you from dipping into extreme levels. Prompt payment discounts help to improve the availability of working capital. 

The longer a business waits to get paid, the more risks there are involved. Especially if you have a vendor that still mails checks. Offering business owners an early payment discount puts you ahead of other vendors and reduces the risks of nonpayment.

Final Thoughts

Adding discount terms to a pay cycle benefits both the vendor and the customer. It’s a win-win situation for all parties involved. Not only does it assist with cash flow problems, but a company can also avoid late payments and strengthen business relationships.

Overall, early payment discount terms add to your bottom line and create more working capital for business growth.