Dynamic Discounting: a Worked Example

A buyer that pays at 60 days is borrowing from its suppliers for 60 days. If it holds more cash than it needs, it can reverse part of that borrowing: pay some invoices early and ask for a discount in return. The industry's standard definitions treat this as a variant of payables finance in which the buyer funds the early payment itself. No bank or specialist financier is involved, and the arrangement usually runs through a platform where approved invoices are offered for early payment and suppliers choose which to accept.

For the buyer, the return is the discount captured, set against what the cash would otherwise earn. For the supplier, it is a choice made invoice by invoice, which is the feature that separates it from a fixed early-payment term printed on every invoice.

The rate is the term that matters. Some programmes publish one rate for all suppliers; others let suppliers offer their own rate, and the buyer takes the offers that pay best. Because the discount slides with the days, a supplier can compare it directly with its own cost of borrowing, which is harder to do with a fixed discount.

An electrical wholesaler, constructed for this page like every figure in it, buys US$73m of stock a year, or US$200,000 a day, and pays at 60 days. It holds US$9m of cash earning 4% on deposit. It offers early payment at 8% a year; suppliers covering a quarter of its purchases take it, and are paid at day 20 instead of day 60. Every rate belongs to the example. The buyer's side, in US$ thousands:

One supplier sells the wholesaler US$3.65m a year, or US$10,000 a day, and takes every early payment. Its debtor balance from this customer falls from US$600,000 to US$200,000, releasing US$400,000 once. The discounts cost it US$32,000 a year (3,650 × 8% × 40 ÷ 365). Borrowing the same US$400,000 on an overdraft at 9% would cost US$36,000, so on the example's rates the discount is the cheaper money. At a lower overdraft rate it would not be.

Supply chain finance pays suppliers early with a financier's money, at a price set on the buyer's credit, while the buyer usually pays later than before. Dynamic discounting pays them early with the buyer's own money, so the buyer's creditors fall instead of rising and no third party can withdraw the funding. One stretches the buyer's balance sheet; the other uses its spare cash.

An early settlement discount is offered by the seller, fixed in advance and the same whichever day inside the window the buyer pays. Its implied annual cost can be high. A seller offering 2% for payment at day 10 rather than day 30 gives up 2% to be paid 20 days sooner:

Dynamic discounting is offered by the buyer and the price follows the days. The two can coexist, and a supplier that runs both is reading its own cost of money twice.

DEFINED IN ONE PARAGRAPH → · SUPPLY CHAIN FINANCE → · CREDITOR DAYS →

In the buyer's file the lender asks where the cash comes from. A buyer paying early out of a genuine surplus has made an investment it can stop: if it needs the cash back, it stops offering early payment and its creditors rebuild over the following weeks. A buyer paying early out of a drawn revolving facility is earning a spread between the discount and its own borrowing cost, and using headroom the lender sized for something else. In both cases net debt is higher and creditor days are lower than the business's ordinary terms suggest.

In the supplier's file, the discounts show as a cost of being paid sooner. In many suppliers' accounts they are deducted from sales, so they reduce gross margin rather than appearing as interest. If the supplier finances its debtors, invoices paid early leave its borrowing base as the cash arrives, so the gain in liquidity is only the part the facility did not advance. And a supplier that starts accepting every offer, at any rate, may be telling its lender something about its cash.

HOW BANKS ASSESS A WORKING CAPITAL REQUEST → · LIQUIDITY HEADROOM →