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Companies often provide a variety of incentives to their debtors to clear their payments on time. One of the reasons why most companies don’t pay immediately is to maintain cash flow.
However, with incentives on the table, some companies find that clearing the payment early often helps them save more money, especially in the case of early payment discounts.
An early payment discount is a type of trade discount that companies offer to their debtors. In exchange for clearing the payment early (before the stipulated deadline), the business receives a discount.
Thus, the debtor benefits by paying less than the actual amount due, whereas the supplier unlocks more cash by receiving payment earlier than the specified terms. It helps both the accounts payable and receivable functions within the company, and boosts profitability overall.
When sending an invoice to customers, you can specific the terms and conditions for claiming the early payment discount, and the discount they’ll receive.
It’s important that you make customers aware of the early payment discount. If you’re using a vendor portal, make sure you post the details there too. Once customers know about the early payment discount, they can choose whether to take advantage of it or not.
It’s important to note that early payment discounts are different from quick discounts. These are offered at the time of sale and are given in lieu of cash purchases.
Early payment discounts, on the other hand, are stipulated in the terms that both parties agreed on prior to the sale.
For instance, let’s assume you sell goods to X Company. While they are reliable, they often pay at the last minute, which affects your cash flows. Now, you introduce an early payment discount of 5% to incentivize X Company to pay early.
The discount will then be shown as 5/15 net 45. This means that if the amount is cleared within the first 15 days of the total 45 days, the customer will receive 5% off their invoice amount.
So, if the invoice was generated on 1st August 20X0, the company will actually pay 5% less, which boosts their bottom line.
There are several types of early payment discounts, and vendors often have the freedom to decide the terms and conditions. Here are the most common types of early payment discounts used by companies.
The sliding scale discount is adjusted based on the actual date of payment. For instance, if the APR is 15%, and the company wishes to receive payments within 30 days, they can offer a 1.25% discount.
The calculation is shown below:
15% APR/ 360 (days) x 30 days = 1.25%
Dynamic discounting uses supply and demand to determine the price, with customers often using a cash pool and setting target rate of returns for the cash they pay. This is often used in specific industries. The steps are as follows:
These are simple discounts that are offered in addition to a company’s standard credit terms. The company can offer an additional discount if payment is made within a specific date range.
AP departments can take advantage of early payment discounts by automating their procurement and accounts payable processes. Using SoftCo’s Procure-to-Pay software, AP departments can automate their entire finance process. They can onboard new vendors, review contractual terms, and optimize pricing agreements with vendors, all through a single portal.