Your guide to early payment discounts

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Smooth cash flow and maintaining profit margins are obviously top priorities for small business owners. But payment delays, volatile economic conditions, and unexpected costs can jeopardize both.

But SMB owners do have one option to explore and use to make their money go further: early payment discounts. You can often save significantly on the total cost of supplies in exchange for up front or prompt payments. 

But what exactly are these discounts, and how can companies use them effectively? In this article, we explain the advantages of this scheme and how to qualify.

What are early payment discounts?

Generally speaking, discounting gives buyers better prices for goods, in exchange for some benefit to the seller or supplier. Early payment discounts fit within a broader 

There are two key terms to be aware of:

• An early payment (or “prompt payment”) discount is offered by a company to their customer(s). Or put another way, between businesses and suppliers. The former offers to pay the latter's invoice before the due date, in exchange for a discount.
  
  Early payment discounts are essentially the flipside of late payment penalties. The customer obtains a more advantageous price in exchange for prompt payment, and the supplier has access to the cash it needs sooner.

• A trade discount is a broader form of agreement between the buyer and seller, usually to incentivize buying in bulk (and not just paying promptly). In most cases, the discount received will reflect the amount of stock purchased. So if you buy 1,000 units, you may get 10% off, but 10,000 units might get you 20%.
  
  Of course, this is essentially the same as discounts offered to all forms of consumers in any market or industry. But as a wholesale buyer, you stand to gain more (and more often) from these discounts. And as a loyal customer with healthy supplier relationships, you should be able to negotiate better rates than the average consumer. 

Why use early payment discounts? 

You may find yourself on either or both sides of this equation at the same time — obtaining supplier discounts and offering them to your own customers. In both cases, this is a valuable way to optimise your cash flow cycle. When customers pay in advance, you avoid the time lag between costs incurred and profits made. 

As a buyer, you get more for your money and effectively increase profits. As long as you have the cash available, you can take advantage of timely offers. So both customer and creditor can optimise their working capital through this solution. 

Used wisely, this is almost a form of financing, and much more accessible than other solutions such as bank loans or factoring. If you can make your money go further, you may not need bridging loans. Even better, you can actually use short-term financing and working capital loans to take these discounts while they’re on offer. If the interest or fees for the loan are lower than the amount saved via the discount, you leave the transaction with higher profits. 

How to benefit from an early payment discount

Whether you want to offer trade discounts to your customers or take advantage of them with your suppliers, here are the steps to follow. 

1. Understand the payment terms

As we have just seen, trade discounts apply a specific rate to the amount of the invoice to be paid, including VAT. This offer is valid for a limited period (the discount period). The discount on the final price is only applicable if the customer settles the transaction before a deadline. After the discount period, the customer must pay the original invoice price in full.

The discount conditions must therefore be clearly stated in the sales contract and on the invoice. Avoid any misunderstandings. 

And as the buyer, make sure you read any fine print and understand fully the terms of the discount. This is particularly important if you use financing. You don’t want to take on an extra burden, only to realise you won’t receive the discount you anticipated.

2. Maintain good supplier/customer relations 

Commercial discounting offers many advantages to both parties involved. Open communication between supplier and customer is also crucial. In some cases, the customer pays in advance for goods they will not receive until a few weeks (or even months) later. The supplier must therefore be able to deliver the purchased product on time and keep the customer informed of any progress in production/delivery, etc. 

On the customer side, the trade discount can also help to maintain good relations with your supplier. You’re giving them what they need: cash in advance. As a result, you may benefit from other advantages in exchange for this discount, such as: 

• Priority on exclusive goods
• Faster delivery times
• Advantageous payment terms when your company needs them

These may seem like small advantages. But when margins are tight and working capital is always at a premium, they can make a huge difference. 

3. Ensure you have the cash required

As a buyer, you can only take advantage of early payment discounts if you have the funds at hand. Which isn’t always a sure thing.

This requires an efficient cash conversion cycle — keeping money coming in on time and in full. There are two levers to ensure you have enough cash: 

• Focus on your accounts receivable process, so that customers pay on time. In fact, offering your own discounts here can really help. And you may need to sharpen up your collections.
• Open a line of credit (similar to a bank overdraft), reserved for these special cases. This is like a loan or factoring arrangement, but is ready to use whenever you need it. 

The cash conversion cycle — and working capital in general — is an often overlooked part of running a small business. But you need to spend money to make money, and you need to have money to spend it. 

How to calculate trade discounts

Clearly, the “correct” level of discount is a percentage large enough to encourage the maximum number of buyers to take it, while also safeguarding profits for the seller. The amount you receive in a trade discount really just depends on the size of the discount offered.

Amount of commercial discount incl. VAT = Sales price incl. VAT x discount rate. 

In most cases, the discount rate will be between 2% and 5% (depending on the total amount of the invoice, but also on how far in advance the invoice is paid). 

Let's take the example of a discount rate of 3% on an invoice of 10,000 euros. 

The amount of the trade discount (including VAT) = 10,000 x 3 (i.e. 300 euros). 

The amount of the invoice to be paid, including VAT, will therefore be 9,700 euros. 

Get the credit you need to make smart moves

Early payment discounts are a wonderful tool. But you need to have the cash to take advantage of them. 

Defacto offers fast, flexible, and fair working capital loans for exactly these occasions. Open a line of credit that you can dip into (and repay) any time, as the need arises. 

All with complete security and in just a few seconds. So you never get caught short of the cash you need, and can put all your effort towards building a growing, sustainable small business.