Should You Use Financing to Get an Early Payment Discount?
As a small business owner, you try to save money whenever possible, and early payment discounts are one of the ways you can. However, you might be wary of parting with your cash earlier than planned, or you might not have cash immediately available.
Does this mean the discount isn’t an option for you? Not necessarily. You might still be able to take advantage of the discount by strategically using flexible financing.
Let’s take a closer look at how early payment discounts work and the formulas you can use to determine if the discount is worth your while — whether you’re paying with cash or financing.
How Do Early Payment Discounts Work?
Early payment discounts — sometimes called prompt payment discounts — offer cost savings when invoices are paid before their due date. They’re most common in B2B transactions with net-30 payment terms (or even with net-60 or net-90 trade credit terms).
Generally, it’s not enough to simply pay any time before the due date. You’ll need to follow the early payment discount terms listed on the invoice. These usually specify that the payment is due within a certain number of days, such as within 10 days of the invoice date, to receive the discount. If you don’t make a payment within that timeframe, you’ll owe the full invoice amount due.
If a buyer doesn’t have the cash on hand to make an early payment, they can use supply chain financing or a business line of credit to take advantage of the discounted pricing.
Types of Early Payment Discounts
There are a few different types of early payment discount programs that businesses can employ:
Static discounts: This is the simplest program option. The company sets a discount rate and an early payment timeframe. Typically, a business will offer a 2/10 net-30 discount. That’s a 2% discount if you pay within 10 days (or 20 days early).
Sliding scale discounts: This is similar to a static discount, except a different discount percentage is available depending on how early you pay your invoice. For example, you might receive a 2% discount if you pay within 10 days of the invoice date and a 1% discount if you pay within 20 days. Then, you owe the full amount if you make your payment between 21 and 30 days.
Dynamic discounting: With this option, buyers and sellers negotiate on when the payment will be received and what the discount will be. For this type of early payment discount program, it’s helpful to use a platform that can automate the process and allow for real-time negotiations.
How to Decide If You Should Take Advantage of an Early Payment Discount
If you’re able to pay a discounted amount for something, it might seem like a no-brainer, right? But when deciding if an early payment discount is worth taking advantage of, you need to consider how you will be paying the invoice and the opportunity cost involved.
In most cases, you will either pay with cash on hand (such as from a business checking or savings account) or with financing. If you’re paying with available cash, determine where that money is stored, whether you’re earning interest on it, and its rate of return. If you want to use financing to pay the invoice, know your annual percentage rate (APR).
Armed with this information, you can calculate the effective APR of the early payment discount. The effective APR is essentially the rate of return you receive from taking the discount. Compare that with the current rate of return of your cash or financing APR to see which payment options are advantageous.
How to Calculate a Discount’s Effective APR
There are two formulas you can use to calculate the effective APR of the discount.
The simpler equation is: APR = (Discount rate / Days paid early) × 360
So, if you get a 2% discount for paying within 10 days (or 20 days early on a net-30 due date), your effective APR would be 36%.
(.02 / 20) x 360 = 0.36
The more detailed equation is: (Discount rate / (1-Discount rate)) x (360 / (Full Payment Due Date-Discount Period))
With this calculation, the math looks a little different, and you’ll get a more specific result, but the answers are essentially the same. Let’s look at the math for a 2/10 net-30 discount:
(0.02 / (1 - 0.02)) × (360 / (30 - 10)) = 0.36738
That would be an effective APR of about 36.74%.
The next step is to compare it to the APR of your cash and/or financing.
Here are two situations where it would be beneficial to use cash or financing to take advantage of the early payment discount:
Cash: If your cash is earning 5% APR in a savings account, but taking the discount gives you a 36% effective APR, you’ll get a higher rate of return by strategically using the cash to pay early.
Financing: If you have a business line of credit with a 10% APR, but the discount gives you a 36% effective APR, you’ll earn a higher return than what you’d pay in interest.
However, what if the early payment discount is 1% for paying 20 days early? That would be an effective APR of 18%. Would that rate of return still be beneficial? Again, you’ll want to compare it to your cash’s rate of return and your financing facility’s APR:
Cash: If your cash is getting a 10% rate of return, the 1% discount would still be worthwhile since you’d receive an 18% rate of return.
Financing: If your financing facility has a 22% APR, you would be spending more to borrow the money than you would gain from taking advantage of the discount. In this case, you’d be better off using different funds to get the discount or simply waiting and paying the full amount of the invoice.
Benefits of Early Payment Discounts
The best part of early payment discounts: They’re a win-win for both buyers and suppliers.
For buyers, the possible benefits include:
Saving money
Improving supplier relationships
Reducing the risk of late payments and late fees
For suppliers who offer early payment discounts to customers, the possible benefits include:
Closing accounts receivable quicker, which provides better cash flow
Increasing your supplier prioritization position, meaning you might get paid by customers before their other suppliers
Take Advantage of Early Payment Discounts With Backd Financing
Early payment discounts let you save money and maintain good supplier relationships. However, you might not want to dip into your available capital if it’s not financially advantageous. You could be better off using flexible financing as a strategic savings tool in order to cash in on the discount. By comparing APRs, you can evaluate the opportunity cost and make a data-driven decision.
With Backd’s Business Line of Credit, you can have the funding you need whenever you need it, even to pay invoices early. The application* only takes a few minutes, and the eligibility requirements are straightforward:
$100,000 in monthly revenue
A 650+ credit score
Established business credit
Based in the U.S. with a brick-and-mortar address
Been in business for two years
Apply now and receive a funding offer within as little as 6 hours**.
* Your application, including the amount, cost, and approval, is subject to review and is not guaranteed. Terms and conditions subject to change without prior disclosure or notice.
**Decisions and funding may take additional time and not be same-day. Additional information may be required. Time to receive funds varies based upon your financial institution's receiving schedule and operating hours.
