August 19th, 2021

When it comes to paying off an invoice in a business-to-business (B2B) transaction, the sooner the better for all parties involved. Oddly enough, buyers typically wait until the due date to remit their payment. So what’s the holdup?

9 times out of 10, buyers remit payments at the last minute to optimize working capital. In other words, they want to spend their money on the things that can have the most impact on their business, say, digital transformation. So even if they’re sitting on a pile of cash, there’s not really any reason for them to send the payment early unless their goal is to reduce their days payable outstanding (DPO). But let’s be honest: They’re probably trying to increase it.

That’s the exact opposite of what suppliers are trying to do, however. That’s because, in order for suppliers to optimize working capital, they need to lower their days sales outstanding (DSO).

Fortunately, there are two possible financing methods that have the potential to result in a win-win for both parties: dynamic discounting and supply chain finance. In utilizing one (or both) methods, buyers and suppliers can achieve their goals despite conflicting motives.  

What Is Dynamic Discounting?

Dynamic discounting is when a supplier agrees to give a buyer a discount on goods and/or services purchased if the invoice is paid early. The discount is often a percentage of the full invoice (i.e., 5%), and the amount typically depends on how quickly the payment is made.

As opposed to more traditional early payment discounts, dynamic discounting is applied on an invoice-by-invoice basis. Suppliers chooses which invoices are eligible for an early payment discount and which are not. The agreement isn’t static and is subject to change at the suppliers’ own discretion. Hence, dynamic discounting.  

In order to pay the invoice early, the buyer needs to have cash on hand that is generating little to no return. To clarify, the buyer should not participate in dynamic discounting if the only cash available to them is being used to fund other strategic transformation and financial initiatives (i.e., debt settlement). That being said, if the buyer has an abundance of cash, dynamic discounting can be a viable solution to boost profitability on cash that would otherwise be earning (minimal) interest.

Pros: Dynamic Discounting Benefits for Buyers:

  • Increased profitability. Early payment discounts on goods and/or services often provide a larger return than potential interest earned.
  • Low risk. Investments are funded by excess cash.
  • Optimized working capital.More cash is brought into circulation.
  • Strengthened supply chain. Early payments increase flexibility and reduce the likelihood of any disruptions.
  • Automated early payments. With an EDI or e-invoicing solution, buyers ensure that they never miss a payment and always receive the discount.
  • Improved relationships with suppliers. They also reap some dynamic discounting benefits!

Pros: Dynamic Discounting Benefits for Suppliers:

  • Optimized working capital. Dynamic discounting lowers DSO and increases cash on hand.
  • Improved financial forecasting. Suppliers decide when they want to get paid and can better predict future cash flow as a result.
  • Enhanced flexibility. Suppliers decide which invoices are eligible for dynamic discounting.

Dynamic Discounting Cons

Overall, dynamic discounting is a low-risk financing option for buyers that want to boost profitability and give their suppliers the benefit of early payments. However, by participating in a dynamic discounting scheme, suppliers agree to reduce their prices and take a slight hit on their own profitability as a result. Many suppliers, especially SMEs, do this willingly—it’s more important for them to lower DSO and increase cash on hand if they want to invest in growing their business. But before rushing into a dynamic discounting agreement, it’s important for suppliers to assess their financial soundness to first ensure that they can afford to do so.

What Is Supply Chain Finance?

As opposed to dynamic discounting which is funded by a buyer’s excess cash, supply chain finance (SCF) involves a third-party financing provider.

In this model, also called reverse factoring, a bank or other third-party financing provider pre-finances supplier invoices. What that means is that a supplier receives the payment for an invoice as soon as it has been approved by the buyer. But instead of receiving the payment directly from the buyer, payment is remitted by the bank or other third-party. The buyer is then responsible for paying the invoice amount (plus a fee) back to the third-party institution according to the payment terms (e.g., net 60).

Supply chain finance is often utilized when a buyer doesn’t have a surplus of cash available and wants to optimize working capital by extending payment terms. This situation also offers quick payment opportunities for suppliers, but depending on their size, supply chain finance may not be sustainable or even possible.

Pros: Supply Chain Finance Benefits for Buyers:

  • Optimized working capital. In exchange for getting paid early, suppliers extend payment terms. This leads to an increased DPO.
  • Strengthened supply chain. Early payments provide easy access to working capital for suppliers and reduce the likelihood of supply-and-demand-related disruptions.
  • Improved relationships with suppliers. They also reap some supply chain finance benefits!

Pros: Supply Chain Finance Benefits for Suppliers:

  • Optimized working capital. Supply chain finance lowers DSO and increases cash on hand.
  • Improved financial forecasting. In exchange for extending payment terms (e.g., from net 30 to net 90), suppliers receive near-immediate payments and can better predict future cash flow as a result.
  • Low-cost access to capital. Supply chain finance is based on the creditworthiness of the buyer rather than the supplier. If the buyer’s credit is higher, the supplier has access to working capital at a lower cost than if it were self-financed.

Supply Chain Finance Cons

The biggest downside to the supply chain finance model is that it’s typically reserved for a buyer’s top 1% of suppliers. This is unfortunate because the smaller suppliers are most often the ones that would benefit the most. In fact, in many cases, large suppliers actually have a better credit rating than the buyer. SCF works best when it’s the other way around.

In other words, supply chain finance can be a sustainable solution when a buyer can loan money (capital) from a bank at a lower interest rate than their suppliers. Adding to this, supply chain finance becomes even more sustainable when it can be offered to smaller suppliers as well, especially if the buyer extends payment terms for all suppliers. This could end up having the opposite effect on the supply chain and supplier relationships since unqualified suppliers will not receive financial support and will have to wait significantly longer to get paid.

So, What’s the Verdict: Dynamic Discounting or Supply Chain Finance?

The answer to this question depends on your position as a buyer. Do you have a lot of excess cash and want to boost profitability, or do you want to have greater access to working capital by increasing DPO?

If you have an abundance of cash, then it makes sense to opt for dynamic discounting. It’s low risk, and there’s a good change that the majority of your suppliers will be willing to participate. Because of this, dynamic discounting is the more sustainable solution of the two. But if you also want to enjoy longer payment terms and have more cash on hand, you don’t necessarily have to choose one over the other. A combination of both dynamic discounting and supply chain finance may be the best solution.

A Bit of Advice: Do You Want to Benefit from Early Payment Discounts?

Regardless of whether you’ve entered a traditional early payment agreement or a dynamic discounting arrangement, invoice automation is critical when it comes to ensuring on-time payments.

Here’s an example: Suppose the reduced payment period is 10 days. For organizations that rely on manual processing, it’s (almost) impossible to get the invoice approved within that time frame. Invoice automation ensures that you’ll never miss out on a discount due to a late payment.