Is it wise to take advantage of early-payment discounts offered by suppliers? Or should you make other use of your cash until payment is due? There are lots of things to consider.
We’ll kick off the discussion with a simple example. Let’s say we’ve just opened our business selling widgets, and we have $10,000 on hand. Let’s further say that we have monthly expenses of $2,000. We could invest everything that’s left and buy $8,000 of widgets that we’ll attempt to resell for $16,000. That would be a pretty good first month.
But we first have to order the widgets, then receive them, then sell them, then bill for them, then collect on those sales — and then we’ll have that money in hand to pay our bills. That’s really all working-capital management boils down to: making sure to have a big-enough (but not too big) buffer on hand to pay what needs to be paid at all times. If the buffer is too small, we won’t be able to make a payment. If it’s too big, we’ll miss out on opportunities to profitably invest that cash elsewhere.
Assuming we’re able to make our initial purchase on credit, we’ll get our shipment of widgets in a week or two while still holding onto (i.e., making profitable use of) our cash. Then the invoice will arrive. To decide whether to take advantage of early-payment discounts or keep on holding our cash for a bit longer, start by asking some fundamental questions:
1: How quickly will the invoice make it to accounts payable?
2: What process (if any) will AP go through to confirm the bill is accurate?
3: What process will AP use to confirm we got what we ordered?
4: Who needs to sign off?
5: When can a check be cut or electronic payment initiated?
If we can make it through those five steps quickly —in less than 10 days, say — it typically will be worthwhile to part with our money earlier in order to send a little bit less than we otherwise would have a few weeks from now.
If it takes longer to work through the process, there is another choice to make: Do we pay as soon as the invoice has been processed? Or do we take the discount anyway? Assuming we’re able to control when payments go out (i.e., we have some check in place in between invoice approval and payment authorization), the answer to the first question is an emphatic NO.
The answer to the second question should be “no” as well, for two reasons. First, taking unearned discounts while still holding onto our cash is ethically and legally (though not criminally) wrong, of course. Second, because the discount was unearned, our supplier will have a valid claim against us — we really do owe them the full amount, even if they accept the partial payment. We’ve already agreed to the terms; sending a different amount doesn’t equate to a counter-offer. We may be placed on credit hold, preventing future orders until the deficiency is made up; or we may just see that balance carry over to the next invoice.
If we’re not all too concerned about honoring the terms of our contractual agreements, options open up. For example, there’s also an interesting decision to be made if the term we ignore is the maturity date rather than the discount cut-off. Here’s an illustration (don’t worry, we’ll explain what’s going on in the chart):
Here’s the explanation: We’ve bought $1,000 worth of widgets and want to know which approach to payment benefits us the most, with the added assumption that we can earn a 10% return on the money we hold onto. To do this, we pick an arbitrary reference point of 120 days beyond the invoice date. If we pay on Day 30, as agreed, we would have earned a little bit of return in that first month ($8.22), which would grow ever-so slightly over the course of the next 90 days — all in all, not an inspiring outcome.
If we’re fast enough to take the discount, we wouldn’t earn much return on the base amount, but from the payment day forward we’d have a bulky $22.74 upon which to keep building.
Finally, if we ignore our contractual obligations, we find something interesting: even if we hold onto our cash and pay a full month later than agreed upon, we’re still $6.61 worse off than if we had taken the discount. It’s not until we’re about two full months late that the profitability swings in our favor. The higher our available return (how much we can make from the money we hold onto), the faster the unethical approach wins out over the honest discount. That said, the discount-based savings are the only ones that are truly ours to keep — it may just be a matter of time before our supplier comes to us to square things up (including pre-negotiated late-payment fees, which further erode the late-payment benefit) or drops us as a customer.
Getting Creative: Third-Party Funding
If you’re efficient enough to achieve a discount and want to honor the terms of your agreements, there’s another option: third-party financing of your payables, commonly referred to as supply-chain finance (SCF). The way it works, you receive, process and approve the invoice quickly. You get in touch with an SCF provider, who registers that approved invoice and facilitates an offer to your supplier: it can get paid earlier, at a discount. You still pay at the maturity date. Nothing really changes, except the source of the money used to pay the supplier earlier. The SCF provider will benefit (usually with some sort of split) from the discount-based savings.
There’s a wrinkle in this, however. If we look back at the table above, we see that paying early with a discount is preferable to paying full price on time. So why would we choose to pay on time, regardless of where the money comes from? The answer is that we won’t be offering this SCF option by itself; we’re going to use our negotiating leverage (if we have any) to push terms out first, and then offer to reduce the sting a bit by enabling our supplier to receive funds earlier. From the table, we know that our target will have to be around 90 days in order for the additional return we make to outperform the original 2% discount. And how will that happen?
AP may have the skills to pay the bills, but procurement’s got the smarts to buy the parts. The payment terms AP looks to maximize are negotiated by procurement, as are the prices and line-items they match as part of the approval process. Cross-departmental collaboration is incredibly important here: an efficient AP process won’t drive savings if there are no discounts to capitalize on. Similarly, if AP isn’t yet efficient enough to take advantage of a discount, procurement’s energy (and leverage) is best spent on things like item pricing, freight-expense allocation (i.e., getting the supplier to cover) or maturity-term extension.
A final thought: Is it better to reduce item pricing by $1, or save $1 through early-payment discounting? That’s like asking what weighs more, a pound of feathers or a pound of bricks. They both help preserve the same $1 on its way to the bottom line, with a possible excursion to state and federal tax before reaching its final destination with 50-75% or so intact.
Still, as others (and math) have persuasively pointed out, $1 of savings produces the same result as $10 of additional sales for a business with a 10% margin. Regardless of the exact figures, it’s a good thing to manage toward.
Scott Pezza is principal analyst at Blue Hill Research. His focus is on accounts payable, accounts receivable, electronic invoicing, dynamic discounting and supply-chain finance. This article was originally published on Blue Hill’s website.